(PUB) Investing 2016

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The Case for Core Bond Funds Income Strategist | Cara Esser

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

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% .

as boring, in many cases, boring is best. K Contact Cara Esser at cara.esser@morningstar.com

Investors seeking traditional bond exposure—gener- ally a mix of ballast, diversification from equity risk,