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Bonds: How to Invest in Them Now

This article was updated on May 4, 2011

Inflation fears are rampant, gold and oil prices are spiking and the world's biggest bond fund manager is betting against U.S. Treasury bonds. Where does that leave you? As a diversified, long-term investor, you can't just cut and run, but bonds do look scary. Yields on10-year Treasury bonds have climbed in the last six months, to about 3.3percent from 2.4 percent, partially reversing a rally that took yields close to their lowest levels since the early1950s. With yields backing up, and with Federal Reserve Treasury bond purchases – the program known as quantitative easing, or QE2 – expected to end soon, wariness toward bonds of all sorts is palpable among investment advisers.

Few are advocating abandoning bonds altogether. Whichever way bonds move from here, they will remain vital holdings, advisers say, providing diversification and stability to a broader portfolio. Treasuries and high-grade corporate bonds often move in the opposite direction of equities and so serve as hedging tools. Still, they caution that returns are likely to become more meager or worse.

“We think bonds are very risky,” said Harold Evensky, president of Evensky & Katz Wealth Management. “Rates are very low, and there’s a high probability that they’ll be going up in the next few years.”

Evensky, like many economists, expects inflation to reemerge as the economy finds its feet. That precarious backdrop makes acquiring the right mix of bond funds and especially the right mix of managers critical.

As with equities, bond portfolios can be actively managed or passively track the performance of an index. Each strategy has its pros and cons, and while generally advocates indexing, Timothy Strauts, an analyst at Morningstar, sees potential pitfalls.

“Indexing bonds is much harder because bonds are a much more heterogeneous asset class,” he explained. “Companies can have 40 different types of bonds with different maturities. Also, bonds trade differently. They don’t trade on exchanges; trades are done through people calling each other.”

Active managers may be able to benefit from the thinness and obscurity of bond markets more than stock markets, he observed. Those characteristics are also a key reason, by the way, that smaller investors should fill their portfolios with funds, not individual bonds.

Higher Costs, Higher Returns?

The positive aspect of index funds of bonds and stocks alike is their lower cost, although Strauts said that it’s easier for active managers to beat bond indexes than stock indexes, especially in certain niches.

“Mortgage bonds are more complex than other types of bonds,” allowing good managers to add value, he said. By contrast, “for someone who focuses on Treasuries, there’s a lot less you can do.”

Ron Carson, head of the financial advisory firm Carson Wealth Management Group, highlighted a shortcoming of bond index funds that may make them particularly problematic in the months to come: It’s common for some types of bonds to rise while others decline or remain flat, so returns on broad indexes can be diluted.

“Indexing works in a huge bull market,” Carson said. “When we’re going to be in a choppy, sideways-to-down market, tactical asset allocation is where you need to be.”

That’s fine if you’re a master tactician with the know-how to put money in the right assets at the right time, but that’s a lot to expect of amateur investors (indeed, it’s a tall order for a lot of pros). They might be better served, financial planners say, trusting big chunks of their portfolios to managers with remits to invest across many segments of the bond market, wherever they see fit.

“These markets lend themselves to constant changes,” said Louis Stanasolovich, president of Legend Financial Advisers. “Most individuals don’t have the data to determine which way to go, so we recommend the most flexible type of portfolios if they’re trying to do it on their own.”

The New Bond Portfolio

The right portfolio of bond funds depends on your financial and personal circumstances and short- and long-term goals. Creating it is often best done with the help of a financial planner. For those who want to take a stab at it themselves, this model portfolio, based on recommendations by the planners quoted in the story, can serve as a starting point. (Percentages refer to the proportion of the bond fund portfolio only, not the total portfolio of which bond funds are a part.)

Stanasolovich offered five funds for consideration, most of whose managers have at least some degree of latitude in where they invest. He encourages buying them in equal amounts, although he might overweight or underweight some as market conditions warrant.

Ranked from most to least manager discretion, he likes Eaton Vance Global Macro Absolute Return, which he described as “almost like a hedge fund that focuses on fixed income”; Loomis Sayles Bond; Osterweis Strategic Income; Templeton Global Bond and Eaton Vance Floating Rate.

Stanasolovich recommends keeping 30 percent of a total portfolio in bonds, although aggressive investors might go as low as15 percent and load up on stocks. He also emphasizes the importance ofrebalancing; at least every six months investors should return the balance between stocks and bonds to preferred levels and return the individual fund holdings to equal weights.

Recommending the Bond King

Carson, a fan of Bill Gross and Daniel Fuss, the brains behind Pimco's and Loomis Sayles' bond funds, respectively, also recommended Loomis Sayles Bond and Pimco Total Return, as well as Pimco Income.

"I definitely would give managers as much flexibility as possible to get yield and boost total return," Carson said. "Gross can do a lot of different things; he has done a phenomenal job."

Evensky, another planner who puts a premium on flexibility, thinks that funds with wide latitude will come in especially handy during the testing markets that he anticipates. Two that he recommends are Pimco Unconstrained and J.P. Morgan Strategic Income Opportunities. He said that he and his colleagues had moved “a fair amount of our portfolio” into those funds.

Evensky also would devote as much as 30 percent of a bond portfolio to Treasury inflation protected securities, or TIPS, whose interest payments rise and fall in line with consumer prices, and generally go for bonds that have shorter maturities and higher quality. He declined to name specific TIPS funds or managers.

As big a fan as he is of holding flexible funds, he counsels against overdoing it. Even the best managers have a way of coming up with the same bright idea at the same inopportune time, potentially leaving investors heavily and unwittingly exposed to one segment of the market.

“As for recommending a total allocation to these funds, intellectually it would make sense if you assume they will work as advertised,” Evensky said. “However, experience tells me this is not necessarily the case. Bottom line: Investors will have to do some of their own allocation decisions.”

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