The Risks and Rewards of Diversifying Your Bond Funds

Baby boomers investing for retirement back in the ’80s, ’90s and ’00s rarely had to worry about the bonds in their nest eggs.

Bonds back then mainly served as risk-reducing ballast for when stocks tanked. And they weren’t that much of a sacrifice because they often paid healthy interest yields of 5% or more.

But now, when boomers are supposed to have increased bond weightings in their portfolios—40% or more of a nest egg, according to the conventional wisdom—rates have fallen to the floor. Interest yields on a bond index fund are as low as 1.1%. As a result, retirees and other index bond investors are left staring at tiny interest coupons and a greater risk of rising rates, and thus of lost principal.

“With interest rates near their historic lows, so close to zero, there’s generally only one direction they can go,” says Steve Kane, a manager of the $90 billion MetWest Total Return Bond fund (MWTRX).

In response, investors might want to consider adding to their fixed-income portfolios some bond funds that can offer higher yields than U.S. bond index funds and offer varying degrees of protection from the risk of rising rates. At the moment, commonly used bond-market calculations suggest that for every percentage-point rise in rates, a U.S. bond index fund will lose about 6% in price, wiping out years of interest receipts.

The main reason bond index funds are likely to get hit so hard is because of a feature in the index funds’ most widely used benchmark, the Bloomberg Barclays U.S. Aggregate. The “Agg,” as it’s known, is heavily weighted to the most conservative U.S. government bonds.

This investment-grade-only index is thus more vulnerable to rising rates because it doesn’t include some riskier categories of bonds such as high-yield, or “junk,” bonds, or floating-rate loans that pay higher interest and are often found in actively managed bond funds.

Indeed, sponsors of some actively managed target-date mutual funds—multiasset funds whose mix of investments grows more conservative as investors age—take action to serve retirees’ need for extra income by adding “diversifying buckets” of funds that aren’t part of the Agg index.

T. Rowe Price Group Inc., for example, puts about one-sixth of the bonds in its target-date fund for 70-year-olds in high-yield (or junk-bond), emerging markets and floating-rate funds. JPMorgan Chase & Co. puts one-fifth of retirees’ bonds in high-yield and emerging markets.

A series of retiree investment models designed by Morningstar personal-finance director Christine Benz allocates 14% to 22% of bonds to such categories, depending on investors’ risk appetites. Such bonds can “bump up yields and provide extra diversity,” Ms. Benz says.

The interest rates on these three kinds of funds may be double or triple that of a bond index fund. And funds that focus on some bonds, like high-yield and emerging markets, often outperform the index over a full market cycle. Funds of both types beat the index in the past decade, according to Morningstar.

These types of investments do make retirees’ portfolios riskier, however. All three categories got hit twice as hard as the safer index early last year, falling more than 20% in price while bond index funds fell just 8.6%, Morningstar says. Stocks fell 35% during the same period. Most of the losses have since been regained.

Still, seeking to avoid such swings is why some target-date fund sponsors, especially index managers like Vanguard Group, tend to avoid emerging-markets, junk and floating-rate bond funds.

Bogus boosts?

Maria Bruno, head of U.S. wealth-planning research at Vanguard, says trying to boost bonds’ return this way is misguided. Ms. Bruno agrees with those who say bonds should be “ballast” for times when stocks tank. “They shouldn’t be seen as a return-generating investment,” she says.

Dan Oldroyd, head of target-date strategies at J.P. Morgan Asset Management, disagrees. Mr. Oldroyd says that with stock valuations “stretched,” adding risk in a bond bucket with high-yield and emerging markets is a reasonable step. Similarly, Kim DeDominicis, a target-date portfolio manager for T. Rowe, says high-yield and emerging-markets funds can offer possible higher returns and guard against rising rates with “modest increases to expected volatility.”

The target-date funds discussed earlier, including similar Vanguard funds, and the Morningstar buckets all include inflation-protected-bond allocations of 7% to 15% of total assets. While those bonds have yields near zero, they can help protect purchasing power if inflation kicks up.

Riskier, higher-yielding assets are common in actively managed bond funds. A majority of the dozen largest report holding more than 5% of assets in high-yield bonds; five say they have more than 5% in emerging-markets debt.

The $70 billion Bond Fund of America has 6.9% in high-yield and emerging markets. Margaret Steinbach, a fixed-income director for the fund, says higher doses of these kinds of riskier allocations “could potentially compromise the downside protection” of bonds.

But others are more gung-ho. “We’ve been adding high-yield and emerging-markets bonds,” says Mike Collins, co-manager of the $64 billion PGIM Total Return Bond Fund, which holds 14.8% in the two categories. He says individuals could hold as much as half of their bonds in such riskier buckets, depending on their time horizon and risk tolerance.

DIY choices

For do-it-yourself index investors who want to add such exposure, Ms. Benz suggests Vanguard High-Yield Corporate fund (VWEHX), iShares J.P. Morgan USD Emerging Markets Bond (EMB) exchange-traded fund and Fidelity Floating Rate High Income fund (FFRHX).

Less-daring options include bumping up the yield only slightly with an investment-grade corporate bond fund, or moving some bond assets to lower-yielding money-market funds or short-term bonds to reduce interest-rate risk.

Morningstar bond-fund analyst Eric Jacobson says retired bond investors can also try to boost returns more safely by choosing an active manager from among top core-plus bond funds—which typically allocate 15% to 20% of their assets to riskier debt—such as Mr. Kane’s MetWest Total Return Bond fund, Dodge & Cox Income (DODIX) or Fidelity Total Bond ETF (FBND).

While that requires paying a much higher fee on one’s entire bond bucket than for a bond index fund, Mr. Jacobson notes that active bond managers have generally outperformed the index, thanks partly to the riskier assets.