Last Updated Apr 27, 2009 3:09 PM EDT
The main role of fixed income in a portfolio is to provide stability, which is especially important during years like 2008. The danger of straying from this strategy and stretching for yield is that the risk of junk bonds may show up precisely when stability is needed most.
Events last year reinforced this idea. Below are the 2008 returns of the 10 worst performing municipal bond funds and the 10 worst performing taxable bond funds, courtesy of Morningstar. As you can see, investors that stretched for yield paid a severe price.
10 Worst Performing Municipal Funds
- Rochester National Municipals -- -48.9 percent
- Oppenheimer AMT-Free -- -41.6 percent
- Nuveen High Yield Municipal Bonds -- -40.4 percent
- Eaton Vance High Yield Municipals -- -36.8 percent
- Lord Abbett High Yield Municipal -- -32.7 percent
- Eaton Vance National Municipals -- -30.9 percent
- Pioneer High Income Municipal -- -30.8 percent
- Goldman Sachs High Yield -- -30.0 percent
- PIMCO High Yield Municipal Bond -- -28.0 percent
- BlackRock HY Muni Fund I -- -27.4 percent
- Helios Select Intermediate Bond -- -84.5 percent
- Oppenheimer Champion Income -- -78.4 percent
- Helios Select High Income Fund -- -76.1 percent
- Helios Select Short Term Bond Fund -- -69.1 percent
- Highland High Income Fund Class -- -57.0 percent
- John Hancock High Yield Fund -- -48.3 percent
- Van Kampen Senior Loan Fund -- -46.9 percent
- YieldQuest Flexible Income Fund -- -44.2 percent
- Highland Floating Rate Advantage -- -44.1 percent
- JHT High Income Trust Series II -- -43.5 percent
There are two lessons you should learn from the experience of 2008. The first is to never confuse yield with return. The second is that credit risk is correlated to equity risk. When the risks to equities shows up, credit risk tends to rear its ugly head at the same time. Thus, credit risk and equity risk don't mix well together in a portfolio.
That is why I recommend limiting fixed income investments to only Treasuries, government agency debt (generally avoiding corporate bond risk) and the highest investment grade municipal bonds (AAA/AA). If you followed this strategy, you not only would have avoided the severe losses many experienced, but you'd have actually seen the value of your fixed income investments rise in 2008.