Bail (Out) Bonds: Some Bond Funds Could Ease Your Pain

It didn't have to be this bad. You could've had bond funds in your portfolio.

Many of the TMT (technology/media/telecom) stocks that breathlessly pushed the market to such stunning heights are now back to where they were a year ago. Last Wednesday I looked at what you might do to rebalance your equity portfolio and reduce risk going forward. Today, let's walk through the argument for including bond funds in your portfolio, which might make sense for even the most aggressive and long-term investors.

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Here's the short version: Putting a modest portion of your portfolio in bond funds will reduce your portfolio's volatility more than it reduces its returns over time.

As great as this sounds, investors have taken a pass on bonds, which have historically returned less than stocks. After all, in 1999 the Wilshire 5000 index -- a broad measure of stock market performance -- gained more than 20% for a fifth-consecutive year, 180 stock funds posted gains of more than 100% and the average tech fund rang up a 135% gain. It doesn't help matters that bonds had one of their toughest years in recent memory in 1994, when rapid-fire interest rate hikes made outstanding bonds less attractive.

Trounced Stocks' solid run in the 1990s gave investors little reason to look at bonds.

Source: Stocks represented by the Wilshire 5000 index, bonds represented by the Lehman Brothers Aggregate Bond index. Performance through Nov. 21.

Consider that from 1995 to 1999 the number of stock fund accounts more than doubled, rising from 69.4 million to 149 million, according to the Investment Company Institute, the fund industry's trade group. Over the same five-year span the number of bond fund accounts flat-lined from 20.8 million to 20.7 million. Through Sept. 30, investors yanked $46.4 billion more out of bond funds than they invested this year, according to Boston fund consultancy Financial Research.

Bond Funds' Flagging Fan Club In the tail end of the 1990s the number of bond fund accounts flatlined, while stock fund accounts skyrocketed.

Source: Investment Company Institute.

Despite their unloved status, bonds' returns aren't negligible. Over the past 15 years the Lehman Brothers Aggregate Bond Index averaged 8.7% annual returns through Nov. 1, compared with 17.5% annualized returns for the S&P 500, according to Morningstar.

A $10,000 investment 10 years ago in the (VBMFX)Vanguard Total Bond Market Index, which tracks the Lehman Brothers Aggregate Bond Index, would've grown to $22,278 by Nov. 1. For comparison, the same investment in the (VFINX)Vanguard 500 Index, which tracks the S&P 500 index, would be worth $51,733.

Of course, translated into dollars and cents, the difference between a 8.7% annualized return and an 17.5% annualized return is a big deal and that shouldn't be ignored. But remember that the '90s were an incredible decade for stock market returns.

The real argument for stock investors to bother with bond funds is their prices' tendency to rise and fall less drastically than stock funds -- while their monthly income payments can help smooth the path as well. The average taxable bond fund currently yields just under 7%.

And this is the type of market where that can pay off. Since Jan. 1, the S&P 500 is down 9.2%, while the average bond fund is up 3.4%. More important, when we look over a longer period, the risk/reward argument bears out. If stocks can't keep this record pace, the argument could keep getting stronger.

Over the past 10 years, the performance of model portfolios shows risk dropping faster than returns as bonds are added to a stock portfolio. A portfolio with all of its money in stocks would've averaged 19.3% annual returns over the past 10 years with its worst quarterly loss just shy of 12%. But if 25% of the portfolio were in bonds, its 10-year average annual return still tops 16.5%, while its worst quarter dips to 8%.

A 10% bond position would've still boasted an 18.2% average annual return, dropping the worst quarter to a 10% loss. There wouldn't have been any 12-month period in the past 10 years when the portfolio lost money.

A Tradeoff Yes, stocks outperform bonds, but they can smooth out stocks' volatility too.

Source: Morningstar. Data through Oct. 31.

Of course, bonds are not risk free. Rising interest rate environments can put bond funds in the red, as they did in 1994. A rash of defaulting bond-issuers can do the same, we've already told you how a credit crunch is currently putting high-yield or junk bond funds in a vice this year. Also, bond funds' monthly income payments, even if you reinvest them in more shares of a fund, can create a headache at tax time, unless you own your bond funds in tax-deferred accounts like IRAs or 401(k)s.

But given the most stock funds' current losses, and the fact that the Lehman Brothers Aggregate Bond Index's worst annual decline was its 2.9% in that horrid 1994, it still seems sensible for many stock investors to put a modest portion of their portfolio in bond funds.

If you'd like to check out your options, we've done some of the homework for you. Back at the end of October the Big Screen looked at intermediate-term bond funds, multisector bond funds, and high-yield bond funds. For most stock investors looking to dip a toe in the bond market, the most sensible option is an intermediate-term bond fund. And since expenses and past performance are the key yardsticks for bond fund shoppers, most should start with the ultra-cheap and diversified Vanguard Total Bond Market Index fund or (TARBX)PIMCO Total Return Bond fund, run by bond guru William Gross. If you'd like to skip the PIMCO funds' sales charges, check out (FBDFX)Fremont Bond or (HABDX)Harbor Bond, two no-load funds also run by Gross.

Junk Pile

Maybe this value-style comeback is for real. Last week, Merrill Lynch analyst Bill Katz lowered his earnings estimates on several asset managers, including Stilwell Financial(SV), which is primarily comprised of growth-fund titan Janus funds. Among the asset managers Katz still liked was Franklin Resources(BEN). Why? Because of Franklin's bent toward the value investment style and the strength of its -- surprise, surprise -- bond funds.

And remember last year when the average Janus stock fund gained more than 80%? This year only one Janus stock fund is above-water since Jan. 1 ((JAGLX)Janus Global Life Sciences), and it's closed to new investors.

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