(PUB) Investing 2016

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High-quality bonds are a tough sell these days. Yields
are low so that you are not getting paid much to own
them. On top of that, if they rise, you might lose
money on the underlying bond whether you own the
bond or a high-quality fund. But it doesn’t make
sense to dump them, especially if you have a big fixed-
income stake. Retired investors have long struggled
with how to allocate assets and how much to with-
draw. The well-known 1998 Trinity Study, which
suggested a 4% annual withdrawal rate for retirees,
was updated in 2009 and concluded that an alloca-
tion of 50% to bonds (less for certain investors) would
allow an investor to preserve portfolio value for
25 to 30 years, while withdrawing up to 7% per year.
The 2009 Trinity Study used high-grade corporate
bonds as a proxy for its bond allocation, though other
studies have used intermediate-term U.S. government
bonds with similar results. Most investors will point
out that U.S. government bonds are generally consid-
ered to be the most sensitive to changes in interest
rates because they are default-free. The same applies
to investment-grade corporate bonds, which have
low default rates. However, long-term investors should
not be in the business of choosing bond allocations
based on predictions of the timing and magnitude of
interest-rate movements. What’s more, the yield
curve tends not to shift in a parallel fashion, making it
difficult to predict which bonds will be more or less
affected by changing interest rates. For example, by
mid-February, short-term Treasury rates rose (as
expected), but long-term rates actually dropped. This
was against a backdrop of uneasiness about global
growth and, as a result, the Barclays US Treasury Long
Index gained 6% by Feb. 5 while the Barclays US
Corporate Bond Index gained 0.47%.
Investors seeking traditional bond exposure—gener-
ally a mix of ballast, diversification from equity risk,
and income—should avoid investing too much in
higher-risk bond funds, including those that hold
sizable portions of high-yield bonds, emerging-markets
bonds, and bank loans. These funds have better yields,
but they will not provide the protection investors
need should the equity market unexpectedly take a
turn for the worse. For most investors, a more
“plain-vanilla” bond allocation—one with a diversified
portfolio, minimal credit risk, and moderate interest-
rate risk that will act as a true diversifier to the equi-
ties in a portfolio—is likely the most suitable choice
for a retired investor, with a moderate time horizon,
who makes annual withdrawals from his or her port-
folio. These “core bond funds” typically fall into
the intermediate-term bond Morningstar Category and
generally keep their duration close to the Barclays
Aggregate Bond Index. Many actively managed core
bond funds don’t hold the level of Treasuries that
the index does, though some hold high-yield, emerging-
markets, asset-backed, and mortgage-backed bonds,
so it’s important to know what you own.
In the year-to-date fund performance through
February 2016, you can see why this is. High-quality
funds held up quite well while lower-quality
funds took on losses. The intermediate-term bond
Morningstar Category gained 1.16% while the
high-yield bond category lost 1.35%.
Investors looking for passive exposure to the index
can’t do much better than Vanguard Total Bond
Market Index VBTLX , which charges rock-bottom
fees ( 7 basis points) and has tracked the index’s
returns reasonably well over the long haul.
For more active exposure, investors can look to Metro-
politan West Total Return Bond MWTRX, which
has a Morningstar Analyst Rating of Gold and ranks in
the top percentile of returns over the trailing 10
years through February 2016, or Western Asset Core
Bond WATFX, which often takes the opposite side
of consensus bets, making it a slightly more daring
option. While investors may view core bond funds
as boring, in many cases, boring is best. K
Contact Cara Esser at
The Case for Core Bond Funds
Income Strategist | Cara Esser