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Bonds Remain
The Simple Way
To Diversify
October 1, 2006

Even at today's modest yields, bonds are a buy.

In recent years, investors have ventured far afield, throwing things like real estate and hedge funds into their portfolios in an effort to diversify their stock-market holdings. Yet, if you own stocks, there's a much simpler way to reduce risk: Just purchase a few bonds or bond funds.

The fact is, bonds have been a great diversifier during the current decade, and there's a decent chance that will continue.

Marching Together

Investors with a moderate appetite for risk often opt for a 60% stock/40% bond mix. But, truth be told, this classic "balanced" portfolio hasn't lived up to its low-risk reputation -- until recently.

Consider some data from Ibbotson Associates, a unit of Chicago investment researchers Morningstar. In the late 1950s, there was a negative correlation between stocks and bonds, meaning that when one rose, the other often fell.

But the correlation turned positive in the 1960s, as stocks and bonds increasingly moved in lockstep. And the relationship only got stronger from there. By the 1990s, there seemed scant reason for stock-market investors to own bonds, because bonds appeared to offer so little diversification.

To understand how we got to that point, think about the economic environment. Inflation surged during the 1960s and 1970s, driving interest rates higher.

That long rise in rates hurt bond prices, which move in the opposite direction from yields. At the same time, the new higher bond yields were a drag on stocks, which now seemed less appealing.

All this went into reverse in the 1980s and 1990s. Falling interest rates drove up bond prices, while also spurring interest in stocks, as investors sought alternatives to low-yielding bonds.

"I really feel that that mountain, where we got a big rise in interest rates and then a big decline in interest rates, is a nonrecurring event," says New York economic consultant Peter Bernstein. "The whole fixed-income environment is likely to be more like the distant past, before the late 1950s. If interest rates are going to move in a smaller range and without these long trends, then bonds should again be a good diversifier for stocks."

That's certainly been true so far this decade. In fact, the correlation between stocks and bonds has been negative, just as it was in the late 1950s.

Different Strokes

Will this low correlation continue? I suspect so. Somewhat higher inflation may lie ahead, but a combination of government vigilance and global competition should keep consumer prices largely in check.

That means we probably won't see stocks and bonds buffeted by big interest-rate swings. Instead, the normal business cycle will loom much larger.

When the economy is growing briskly, stocks will gain as investors anticipate higher earnings, but bonds will struggle as folks worry that an overheating economy will drive inflation higher. Conversely, when recession threatens, stocks will suffer as investors fear slower earnings growth, but bonds should thrive as inflationary pressures recede.

Sound like good news for the good old balanced portfolio? There is a downside. While bonds may be a better diversifier for stocks in the years ahead, we won't see the huge bond-market gains enjoyed in the 1980s and 1990s, because interest rates are now so much lower.

That shouldn't, however, stop you from buying bonds. "You don't use bonds to maximize return," argues Scott Greenbaum, a financial planner in Harrison, N.Y. "You use bonds to diversify a portfolio."

As Mr. Greenbaum sees it, bonds play two crucial roles. Not only do they lower a stock portfolio's volatility, but also they can be easily sold at any time to generate spending money.

Mixing It Up

Still, all this raises a key question: Given that we won't have the tailwind of falling interest rates, how should you construct the bond side of your balanced portfolio? Nelson Lam, an investment adviser in Lake Oswego, Ore., suggests dividing a bond portfolio so that a third is in U.S. bonds, a third in foreign bonds and a third in inflation-linked securities.

For the U.S. bond portion, Mr. Lam recommends the Vanguard Short-Term Bond Index and Vanguard Short-Term Tax-Exempt mutual funds. The latter fund holds tax-free municipal bonds, which can be a good choice for high-income families investing taxable-account money.

"If we ever get wholesale overseas selling of our bond market, the one bond they won't be selling is munis, because the only people who own munis are U.S. taxable investors," Mr. Lam notes. He also occasionally buys high-yield "junk" bond funds for the U.S. portion of a bond portfolio, but he isn't keen on the sector right now.

Meanwhile, for foreign-bond exposure, Mr. Lam likes American Century International Bond, with a smaller allocation to emerging-market funds such as Pimco Emerging Markets Bond and Pimco Developing Local Markets. The Pimco funds' D shares are available without a sales commission through discount brokers.

"International bonds are the most important element in the bond strategy, because they offer the greatest diversification for a U.S. balanced portfolio," Mr. Lam says. "While emerging-market debt has been on quite a run, its diversification and risk characteristics are fantastic. Over a 10-year horizon, emerging-market debt is a must."

Finally, for the third of a bond portfolio allocated to inflation-linked securities, Mr. Lam suggests an inflation-indexed bond fund or a commodity fund. You can get both with Pimco CommodityRealReturn Strategy, a fund that owns a mix of inflation-indexed bonds and commodity derivatives.

If you follow Mr. Lam's advice, you could end up owning a fistful of bond funds. That is reasonable if you have a large portfolio. But folks with less money to invest might buy a single fund that spreads its assets across a host of bond-market sectors.

On that score, check out funds like Fidelity Strategic Income, Loomis Sayles Bond and T. Rowe Price Spectrum Income. These funds don't replicate Mr. Lam's target mix. But they include many of the sectors he recommends.

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