Rainy-day money. Sleep-at-night money. No matter what you call it, you need to put part of your asset allocation in bonds.
"The more nervous my clients are, the higher the bond allocation," says Donald Sowa, financial adviser of the Rhode Island-based Sowa Financial Group. "We let people understand that it will pull down the performance of their portfolio in the long run, but it provides safety."
Safety, as it is often said, comes in numbers. In this case, the most important number is the percentage one allocates to fixed income in his or her portfolio. It's a number that is often difficult for investors to calculate, as they try to balance the value of a good night's sleep with the need to make sure they can generate enough income to retire or to send the kids to college.
Developing an asset-allocation strategy -- read the rest of our series here -- starts with age. The younger you are, the more risk you can afford to take. As you get older and approach retirement, you'll probably be less interested in the growth of your portfolio and more interested in capital preservation -- protecting the value of your portfolio from any declines. Preserving your portfolio as you reach your desired retirement age becomes more important since a large decline in the value of your holdings can affect your retirement lifestyle, or even make it impossible to retire according to your plans.
The typical back-of-the-envelope calculation for allocating an asset mix according to age calls for subtracting your age from 100 and investing the difference in stocks. So if you're 40, the quick math would lead you to an asset allocation of 60% stocks, 40% bonds.
After he checks his clients' vital statistics, Sowa says he puts 20% of his growth-oriented investors' money into actively managed bond funds, which he says are preferable for most clients who don't have the money to buy individual bonds.
"Bonds are less of a buy-and-hold strategy than stocks because people don't usually hold bonds to their full maturities," says Sowa. "So it's better to have experienced bond fund managers looking after the portfolio."
Within the fixed-income portion of the allocation, Sowa's bond fund breakdown is 25% high-yield, 25% international (including emerging markets) and 50% high grade corporate and government bond funds.
Sowa's strategy is unique, however, and every financial adviser has a different formula for playing it safe. Rick Bloom, financial adviser for Michigan-based Bloom Asset Management, for example, says he "covers his clients' backsides" by putting 30% of their holdings into bonds if they have a moderate taste for risk. His bond breakdown calls for 20% short-term government, 20% Ginnie Maes, 15% Treasury Inflation-Protected Securities, 15% high-grade corporates, 15% high-yield and 15% global bonds.
A Ginnie Mae is a fixed-income security that represents an undivided interest in a pool of federally insured mortgages put together by the Government National Mortgage Association. The investor in a Ginnie Mae pass-through receives both the principal and the interest from the pool of mortgages.
Bloom says he likes Ginnie Maes for his clients' bond portfolios because he believes there will be less volatility in the sector now that the refinancing boom is over.
Like Bloom, Michael Joyce, a financial adviser at Virginia-based Michael Joyce & Associates, also sprinkles TIPS into his clients' bond portfolios, especially as the risk of inflation in the economy grows.
TIPS are a special type of Treasury note or bond that offers protection from inflation. As with other Treasuries, when you buy an inflation-indexed security you receive interest payments every six months and a payment of principal when the security matures. The difference is that the coupon payments and underlying principal are automatically increased to compensate for inflation by tracking the consumer price index.
"Bonds are often boring, but boring is not necessarily a bad thing," says Joyce. "In fact, sometimes it's the smartest way to invest."
The one risk to bonds that may eliminate some of that boredom is rising interest rates, which would drive down bond prices. The threat of inflation and its resulting effect on interest rates is causing many financial advisers to shorten the maturities of the securities they buy for their investors. Interest rate swings have less of an impact on short-term bond prices compared with longer maturity bonds because there is less risk to the income stream.
Diane Pearson, a financial adviser at Pittsburgh-based Legend Financial Advisors, suggests bank loan funds as a way to maintain a fixed-income allocation while still guarding against a rise in interest rates.
Bank loan funds invest in loans packaged and issued by banks and other financial institutions, mostly to distressed companies. Unlike the typical bond fund, however, which primarily invests in bonds with fixed rates, the securities held in bank loan funds are variable rate ones, which means they change every few months. Therefore, the rates on the loans held in a bank loan fund will rise along with interest rates. In turn, the yield on the fund rises as well.
Pearson says she uses the
Highland Floating Rate fund for her clients. Other notable funds that employ this strategy include the
Sun America Senior Floating Rate fund,
Eaton Vance Floating Rate fund,
Fidelity Advisor Floating Rate fund and the
Franklin Floating Rate Daily Access fund.
Another strategy for investors seeking simplicity is to invest in a single fund that makes all the decisions regarding asset allocation for them according to their risk tolerance. Gartmore funds, for example, has recently rolled out four Optimal Allocations Funds, which are broadly diversified, professionally managed, risk-based funds that are automatically rebalanced quarterly. The fund comprises a suite of other Gartmore funds.
Gartmore Optimal Allocations Moderately Aggressive fund is broken down into 27% core U.S. equity funds, 7% core international equity funds, 16% core fixed income funds and 50% specialty funds, which includes real estate and health sciences.
Gerry Nickels, senior vice president for fixed-income products, says the fixed income is important because it doesn't act like stocks. He reminds investors of the strong performance of bonds in 2001 and 2002, when equity investors were devastated by the collapse of the bubble in stocks.
But that didn't keep anybody up at night, did it?