The Role of Bond Funds for Mutual Fund Portfolios

Investors often have the same common questions about bond funds:

• What kinds of bond funds do I need to think about?
• What are the different degrees of risk between these funds?
• How will this risk relate to my own level of risk tolerance?
• What percentage of my overall portfolio should I allocate to bond funds?

Answering the Questions

Knowing how to answer these questions requires first knowing particular factors that bonds have about them.

Bond Fund Functions

Bond funds usually serve two fundamental purposes in a broader portfolio:

1. Income generation
2. Minimizing volatility in the overall portfolio

Some bond funds might have an auxiliary function of capital appreciation potential.

Risk Factors for the Yield

The interest income of bond funds is known as the yield, and it’s contingent upon several different risk factors. These factors include:

• Credit rating of the specific securities
• Average maturity holding
• Fluctuations in interest rates
• Political stability (foreign bonds)
• Currency fluctuations (foreign bonds)

Credit Ratings

The credit rating of a bond fund measures how safely debts might be repaid to issuers of bond funds. Investment-grade bonds start at AAA before moving into AA, A, and BBB ratings.

Below-investment-grade bond funds are found at the BB, B, CCC, CC, and C rating levels. D-rated bonds are considered to be in default. Three are even lower-rated bonds, and they have even higher yields in order to compensate their investors for taking on more credit risk.

Maturity

Bonds have specific maturity periods. Average maturity is considered be:

• Short-Term: One to three years
• Intermediate-Term: Four to 10 years
• Long-Term: More than 10 years

Interest Rate Fluctuations

Short-term maturities featuring the highest credit ratings are also going to have the lowest rates of rate volatility. When credit ratings go down or maturities lengthen, then the interest rate volatility is likely to go up. This will happen even more if both things happen.

Different Kinds of Bond Funds

There are quite a few options in terms of bond funds you should know so you can make the right choices.

Government

Government bond funds typically invest in the notes and bonds of the United States government treasury. They might also have smaller exposure to obligations from other American government agencies.

Short-term maturities provide the most principal safety but comparatively low amounts of income. Alternatively, longer maturities from the government will provide higher interest rates, although their value and yield will both show more volatility.

TIPS

These are inflation-protected securities that invest in high-caliber inflation-indexed bonds that get issued by both the federal treasury and other agencies in the government.

TIPS usually have lower yields compared to conventional fixed-rate bonds because of their principal adjustment feature for CPI inflation.

If either stagflation or deflation is anticipated, they can be notable risks for holders of TIPS securities.

Government Mortgage

These funds invest in the mortgage-backed securities associated with the GNMA, or Government National Mortgage Association. Expect higher yields compared to other intermediate-term government securities.

Municipal

These funds invest mostly in state-specific or national investment-level municipal securities. The focus is income exempted from any federal income tax. State-specific funds might also be exempt from related state income taxes.

High-yield municipals will invest in lower grades of investment so they feature more income potential but also more risk.

Corporate

A fund in this category puts its resources mostly into investment-grade corporate debt obligations of American businesses. Volatility and yield are more than similar government securities across short, intermediate, and long terms.

The total capital gain and income return potential are also higher than similar government securities. A number of corporate bond funds also put investments into government bonds.

Diversified International

This category of fund invests in mostly high-caliber bonds in other nations. However, a certain percentage, often 15% to 25%, might be placed in lower-caliber bonds.

These do carry an extra risk factor of currency fluctuation. The specific objectives of such funds are often above-average capital appreciation and income.

Global/World

Funds in this category combine characteristics of the previously mentioned diversified international and corporate bond funds for all maturities. Specific objectives include income and capital appreciation happening at above-average levels.

Multi-Sector

These can invest in a number of diversified bond sectors. They might include any combinations of maturity and allocation.

They can also include emerging markets, high-yield, diversified international, corporate, mortgage, TIPS, and federal government securities. Intermediate terms are the average for maturities in this category.

As with other categories on this list, the primary objectives are getting above-average levels of capital appreciation and income. Multi-sector bond funds work well for investors looking for a core bond fund or just a single bond fund to put in their portfolio.

On the other hand, these funds tend to have variable risk factors, which means investors need to look at the percentage difference separating investment grades from below-investment grades in the holdings to they can properly suit their own risk tolerance.

Bank Loan

Bank loan bond funds invest in really short-term senior debt obligations of just 30 to 90 days that banks or other financial institutions might lend to different businesses. They might also be known or marketed as a floating rate loan, and the borrower’s interest rate resets each month.

Bond funds such as these are often rated as being below investment grade, but the objective is taking advantage of the high yield.

High Yield

These funds typically invest in bonds below investment grade. They might be rated BB or lower, and they can include a percentage of foreign debt.

A lot of high-yield funds also invest anywhere from 10% to 20% of their overall assets in preferred equities and convertible securities that produce income.

High-yield bond funds feature risk that ranges from above average to quite high. The percentage of CC or below holdings determines a lot of this. Intermediate-term securities are common. Objectives include high levels of capital appreciation and income.

Emerging Markets

Emerging market bond funds invest in corporate securities and the governments of countries whose markets are considered to be emerging. Such securities usually get rated as below investment grade due to economic underdevelopment.

Intermediate terms are common for the maturity level. High levels of capital appreciation and income are possible, but political stability and currency fluctuations are omnipresent threats.

Guidelines for Bond Allocation

Effective diversification features certain fundamentals, namely spreading out assets over distinct and diverse fund categories. This is done to:

1. Attain certain risk/reward goals
2. Minimize broader portfolio risk

Both of these have to be cornerstones to effective investment strategies.

Choosing bond fund categories and their allocations is often based on:

1. The overall return objective of growth, balance, or income
2. The size of the portfolio
3. The investor’s individual tolerance level for risk

A portfolio’s size can also determine how many bonds funds are included. A larger portfolio demands more diversification, and thus would need more kinds of bond funds included.

Risk tolerance proves to be a substantial element to choosing various bonds and their credit ratings:

1. Conseravative risk tolerances take lower yields and returns so volatility is minimized.
2. Moderate and average risk tolerances take on more volatility so yields and returns are better.
3. Aggressive risk tolerance will put up with the biggest swings in overall volatility to open the door to the biggest returns and yields.

All three of these risk tolerances can work with income, balance, and growth goals if the time horizon is long-term at five years or more.

Bond Allocation Recommendations

The percentage of bond allocation relates directly to the investor’s stages for accumulation and withdrawal. Typically, an investor moves from a certain accumulation stage to a withdrawal stage of retirement.

During this transition, investors should usually boost their allocations in bond funds. The following are four investment-stage scenarios with long-term horizons for all three risk tolerances:

25+ Years Until Retirement

Growth-oriented strategies in this stage allocate 10% to 20% in bond funds. A single multi-sector bond fund might work, but an additional bond fund can also help.

• Conservative: 20% allocation with 10% intermediate-term government/10% multi-sector
• Moderate: 20% bond allocation with 15% multi-sector/5% intermediate-term corporate
• Aggressive: 10% to 15% bond allocation in multi-sector with an optional 5% high-yield

11-25 Years Until Retirement

A growth-focused investment portfolio in this stage should have 25% to 35% allocated to bonds.

• Conservative: 35% bond allocation with 15% in multi-sector, 10% intermediate-term government, and 10% intermediate-term corporate
• Moderate: 35% bond allocation with 20% in multi-sector, 15% in intermediate-term corporate, and 10% in diversified international
• Aggressive: 25% bond allocation with 15% in multi-sector, 10% in intermediate-term government, and 10% in intermediate-term corporate

One-10 years Until Retirement

Growth-oriented investment funds in the soon to retire stage should have half of their total allocation in bonds.

• Conservative: 50% bond allocation should be 20% multi-sector, with 15% in both intermediate-term government and corporate with an option to go 10% intermediate corporate with 5% government mortgage
• Moderate: 50% bond allocation should be 25% multi-sector and 15% intermediate-term corporate with either 10% diversified international or 5% diversified international with 5% high yield
• Aggressive: 50% bond allocation should be 30% multi-sector, 5% emerging markets and either 15% high yield or 10% high yield with 5% diversified international

Retirement

When in retirement, the investment strategy should be income. That means 70% bond allocation in all three risk tolerances.

• Conservative: Start with 25% multi-sector, 20% intermediate-term governmetn, and 5% short-term government, with either 20% intermiedate-term corporate or 15% intermediate-term corporate and 5% government mortgage
• Moderate: Allocate 30% into multi-sector, with 20% in intermediate-term corporate and 5% short-term government with either 15% diversified international or 10% diversified international and 5% high-yield
• Aggressive: Aim for 35% multi-sector, 15% high-yield, and 5% short-term government with either 10% emerging markets or optionally 5% emerging markets/5% diversified international

A Friendly Reminder

Any of the aforementioned long-term situations can be handled using a strategy focusing on balance, growth, or income.

For instance, certain investors might decide to pursue a focus on balance when strategizing in their retirement. That could mean a 50% allocation into bonds with conservative, moderate, or even aggressive risk tolerances.

Every investor should be realistic about evaluating their risk tolerance regularly. Lots of investors decide too much risk to start with and don’t realize what they did until they get hit with substantially negative losses later on.

Be honest with yourself in deciding your own personal risk tolerance. If any huge loss would detract your long-term point of view, then step down to the next risk tolerance level and pick bond fund categories that are less volatile.

The Final Step

Once any investor picks the bond fund categories appropriate to their circumstances and objectives, they need to choose specific funds in those categories.

Effective choices usually are no-load funds that perform above their category average, adhere to known styles and objectives, feature long-tenured management, and have operating expenses on par with or lower than their peers in their category.