Bonds provide income and ballast. Choose the bond fund that’s right for you

Having a diversified portfolio means you should put some of your money in bonds. Assets can not only provide some protection against market volatility, but also generate income.

Still, deciding how to construct the bond portion of your portfolio can seem confusing, especially after 2022’s bond rout and last year’s continued volatility. In October, the Cash flow at 10 years the yield exceeded 5%. Bond yields move inversely to prices, so when yields rise, prices fall.

This year, investors are closely watching the Federal Reserve to see if and when it will begin cutting interest rates.

“As the Fed moves toward lower rates, stock and bond yields should once again move in opposite directions, reestablishing a blend of the two as an attractive risk-return profile,” Morgan Stanley said in its bond market outlook for 2024.

However, investors shouldn’t try to time the market, said Morningstar senior analyst Mike Mulach.

“Try to have as much diversification as possible,” he said. “There will be some volatility; there has been more volatility lately. But there will be a point where you can no longer rely on cash.”

If you want to hold individual bonds, only do so with high-quality bonds, said certified financial planner Chuck Failla, founder of Sovereign Financial Group.

For example, Treasury bills can be purchased through the TreasuryDirect website.

“When you go for individual bonds, you have a very predetermined duration,” Failla said. Along the way, you will earn income and get your capital back when the bond matures.

If you go this route, stagger the obligations — meaning staggered due dates — to meet your specific time goal, he said.

That said, in general, most investors would be better served by purchasing a diversified bond fund, Mulach said.

“It is not necessary to use a sector fund in a very sophisticated way, but simply to focus on high quality bonds and bond funds which traditionally offer the best diversification benefit compared to riskier assets, such as stocks, in your portfolio,” he said.

There are several factors to consider when investing in a bond fund.

“Narrowing down your choices to the cheapest in the universe is a great place to start,” Mulach said.

But price alone is not a barometer. Investors should be aware of interest rate risk, which is the impact of changes in interest rates on the underlying price of the asset. The best way to assess this is to evaluate the duration of the bond fund, Mulach said.

Then there is credit risk. The higher the quality of a bond, the lower the credit risk for investors.

“These portfolios of investment-grade and high-quality bonds tend to offer the greatest diversification benefits compared to the stocks in your portfolio,” he explained.

You’ll also need to decide whether you want an actively managed fund, which typically comes with higher fees, or a passive fund, tied to a specific index. Active bond funds outperformed their passive peers last year, according to Morningstar.

Because of this outperformance, Mulach generally recommends actively managed funds.

However, it’s not that simple. Mulach and Failla said it’s important to look for funds with high-quality managers.

“Look at the record, but don’t be fooled by it,” Failla said. Also look at the default rate, how long managers stay with the funds and what their asset selection process is, he added.

“You want to make sure they have a real process in place … to mitigate the risks that exist in that space,” he said. “There are a lot of good managers, you just have to do your homework.”

Mulach suggests sticking to the mid-base, short-term, and ultra-short-term Morningstar categories. Ultra-short funds typically have durations of less than one year, while short-term funds stick to durations of one to 3.5 years. Intermediate core durations generally range from 75% to 135% of the three-year average of the effective duration of the Morningstar Core Bond Index.

“Even within those categories, just make sure they are diversified strategies, investing primarily in… government-guaranteed investment-grade securities, corporate debt, and securitized debt securities” , did he declare.

Here are some of the best bond funds actively managed by Morningstar.

In some cases, some managers have success rates below 50%, according to Morningstar’s active/liability barometer.

“If you’re throwing a dart in this category, you might be better off choosing a passive strategy,” Mulach said.

For example, the iShares Core US Aggregate Bond ETF can be a great option to simply replicate this index, he said. It can also be a way to avoid additional risk, since active managers typically take more risk to outperform their benchmark, he said.

Failla is also not opposed to passive exchange-traded funds for Treasuries.

“High-quality Treasuries are a very efficient market,” he said. “You don’t need a high-performing analyst team.”

Meanwhile, if you have a higher risk tolerance, you can get attractive returns with lower quality bonds. Just be aware that high-yield bonds have a higher risk of default.

Failla thinks it’s a good investment at the moment. He sticks to high-yielding funds that are actively managed for his clients.

“1%, 2%, 3% of the bonds in this portfolio will default, but if I have 500, I don’t care,” he said. “This is where bond funds shine.”

It looks at each individual’s time horizon to determine their asset allocation and reserves high-yield bonds for what they will need in about 10 years or more.

Finally, keep in mind that income from bonds is taxed as income, unlike stocks, whose earnings are taxed at a lower capital gains rate. For this reason, Mulach suggests keeping your bond funds in a tax-advantaged account, such as an individual retirement account or 401(k).