How to Navigate an Uncertain Bond Market

Rachel Haig: I'm Rachel Haig from Morningstar.com. I'm here with
Morningstar's director of personal finance, Christine Benz, who
recently wrote an article about looming threats in the bond market
and what investors can do about them. Thanks for joining me,
Christine.

Christine Benz: Rachel, nice to be here.

Rachel Haig: A lot of people have been rushing into the bond market. Especially
with what happened in 2008, bonds were looking attractive. But
now they're looking like they might be a little overheated, with
potential increases in interest rates coming. For people who are
retiring soon and need a certain bond allocation, what are they to
do?

Christine Benz: You're right, it's a tremendous conundrum right now, because
people who are nearing retirement or in retirement do need bonds'
stability and protection. A couple of ideas I would throw out there.
One thing you might do is delegate a portion or all of your fixed
income portfolio to an active manager. A couple of funds I like,
good core active funds, would be Harbor Bond, which is a clone of
PIMCO Total Return; Dodge and Cox Income; MetWest Total
Return bond.

These are real opportunistic funds, and so they can go where they
think the bargains are, or avoid the problem spots in the bond
markets. So that's one idea for the core of a fixed-income portfolio.

Another idea would be to shorten up the overall portfolio, so
intermediate and longer term bonds are going to be the most
vulnerable in a rising rate environment. Maybe devote a higher
than normal share of your portfolio to shorter term bonds and bond
funds.

One I particularly like is T. Rowe Price Short Term bond, it's a
corporate-heavy short-term bond fund.

Rachel Haig: It sounds like for people who are nearing retirement, it's not so
much about severely reducing their percentage in bonds, but
maybe it's a case for active management.

Christine Benz: Changing around the allocation a little bit and avoiding those areas
that are likely to be particularly hard hit in a rising rate
environment. So one area would be the Treasury bond space, tends
to react very quickly and negatively to rises in interest rates. That
might be an area of your portfolio you want to think about
downplaying right now.

Rachel Haig: What about for people who have a little bit more time, say 10 to 15
years until retirement? Should they think about reducing their
percentage they have in bonds?

Christine Benz: Possibly. And the fact is everyone who is near retirement or even
in retirement does need an equity allocation. But the good news for
that group is that even though higher interest rates may cause some
short-term volatility in the bond market, ultimately that's going to
translate into higher yields that are available for the bond portion
of your portfolio. But you might consider if you are, say, 10 years
out until retirement, you might consider retaining a higher equity
weighting. Not going crazy, but stepping it up a little bit to
downplay some of the troubles in the bond market.

You might also consider steering a sleeve of what you might
otherwise dedicate to fixed income to, say, a high dividend paying
strategy. One fund I like in this realm would be T. Rowe Price
Equity Income or Vanguard Dividend Growth.

Rachel Haig: Okay. And then traditionally the idea of bonds and making them an
increasing part of your allocation as you near retirement is to
reduce the volatility of your portfolio. Do you think that bonds will
still serve that purpose, to reduce the volatility? And is this a
question seeing reduced yield or seeing real potential for loss?

Christine Benz: If interest rates trend up over a sustained period of time, that could
translate into losses for bond funds. But thing I would keep in
mind is that the magnitude of those losses would be much less than
you would be apt to see in a period of declining stock market. So
while there are risks, I wouldn't get too carried away, too worried
about the risks. I think retirees and pre-retirees still need to be
dedicating a sizable share of their portfolio to fixed income.

Rachel Haig: All right. Thanks for the pointers.

Christine Benz: Thanks, Rachel.

Rachel Haig: For Morningstar.com, I'm Rachel Haig.