Strategies to Avoid Bond-Market 'Bubble'

BOSTON (TheStreet) -- Debate over buying bond funds versus individual securities is heating up again, with no shortage of warnings that a bursting "bond bubble" and inevitable rising interest rates means doom and gloom for the funds.

Chris Philips, a senior analyst in Vanguard Group's Investment Strategy Group, doesn't buy it.

"The total bond market has only lost money in two years since 1976," he says. "Think of all the periods where we had year-over-year rising interest rates, and yet we've only had two years with negative returns."

How much?

Exposure to bonds should typically creep upward as investors age and seek to minimize the risk and volatility of stocks, maintaining wealth rather than necessarily creating it.

Vanguard's target retirement funds, for example, invest a 90/10 percentage split between stocks and bonds for those with a 25-year or more investment horizon. With 20 years until retirement, they recommend an 83/17 ratio; with 10 years to go, 68/32; and a 50/50 allocation upon retirement. After retirement, their designated exposure to bonds moves even higher, to 64% at five years and 70% at 10 years out.

American Funds suggests a slightly different formula: a 5% bond allocation for an investment horizon of 20 or more years, 25% when there are five to 20 years until retirement and 35% with five years to go.

The simplicity of these equations can betray the complexities of how that allocation should be divided among bond categories.

"The next step is to ask what the allocation within the municipal or taxable market should be," Philips says. "A great place to start is looking at what the total bond market is delivering. If the allocation at the aggregate level in the bond market is, for example, 40% Treasury bonds, 20% corporate bonds and another 40% mortgage bonds, then that tends to be a pretty good place to start for someone looking to get an idea of what the market weights are. Start by looking at the broad bond market and use that as a baseline. If you are not comfortable with that -- you want more Treasuries, for example -- then you can always adjust that on your own."

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