Last year was one of the best showings for bonds in more than a decade: Ibbotson Associates' index of long-term government Treasuries returned 26%. In the first eight months of 2009, however, the index lost 11.5%. Bad news for investors, who poured almost $210 billion of new money into fixed-income funds over the same period, vs. $32 billion in net inflows for the whole of 2008.
"The last year has really highlighted the risky side of investing within fixed income," says Steven Huber, a fund manager at T. Rowe Price Group (TROW). Since 1997 the only fixed-income categories that haven't experienced losses over 12-month periods are shorter-term Treasury funds—which are often lumped in with a fund's cash. A Barclays Capital (BCS) index of high-yield bonds has lost more than 31% in a 12-month period. And even an index of the highest-quality bonds has had a year when losses approached double digits.
With jittery stock market investors putting money into bonds, here's a refresher on the fundamental rules of building a sound bond portfolio.
Sticking to basics doesn't mean staying at home. Core bond holdings don't have to consist solely of U.S. Treasuries and investment-grade corporate bonds. "Investors should have allocations to global bonds as well," says ING portfolio manager Chris Diaz. Over the past dozen years, global debt has returned an average of 5.7% a year. Diaz says the sovereign debt of AAA-rated countries currently boasts significant yield advantages over U.S. Treasuries.
Settle for singles. Among Fidelity's target-date retirement funds, not one allocates much more than 10% to high-yield bonds. "You're not looking for your bond portfolio to hit a home run," says Lowell Bennett, a bond fund manager at Mellon Capital Management (BK). "Consistent singles are good."
Stick to funds. Individuals are best off buying funds, not individual bonds. "I don't know that the average investor is even going know what he's looking at," says Ethan Anderson, a portfolio manager and financial adviser at Rehmann Financial in Grand Rapids, Mich. And if you need to sell a bond before it matures, there's no guarantee you'll find a buyer—and no telling what price you'll get.
An investor's ideal fixed-income mix depends, as with stocks, on risk tolerance and time horizon. A resource for figuring out how much and what type of fixed income you may want is fidelity.com/fixedincomechoices. Searching Morningstar.com (MORN) can uncover cheap, highly rated bond funds with low volatility.