Why It May Be Time to Dump Bonds

NEW YORK ( TheStreet ) -- In a recent annual report, Harvard's endowment crowed about its investment performance. During the 10 years ending in June, the portfolio returned 9.4% annually, topping the S&P 500 by two percentage points.

The solid returns can be attributed partly to the shrewd use of private equity and hedge funds. But the Harvard endowment also succeeded because it has been lowering the allocation to bonds and increasing exposure to equities and alternative investments. Since 2008, the bond allocation fell from 15% of assets to 9%.

That has been a winning move recently as stocks soared while bonds languished.

Harvard is not alone in shifting away from bonds. According to Wilshire Associates, the median public pension fund has only 25% of assets in bonds, and many institutional investors are moving away from fixed income. Institutional investors figure that bond yields are puny, and returns could suffer if rates keep rising. When rates climb, bond prices fall. "Many institutions are worried about the prospects for high-quality fixed income over the next three to five years," says Steve Foresti, a managing director of Wilshire.

Should individual investors join the migration from bonds? Yes, say some managers of balanced mutual funds. The funds hold mixes of stocks and bonds, and lately the managers have been shifting away from fixed income. Franklin Income ( FKINX) has lowered its bond allocation from 52% of assets in 2011 to 32% this year. Berwyn Income ( BERIX) moved from 35% of assets in bonds in 2011 to 21% now.

Eaton Vance Bond ( EVBAX) aims to deliver income. To accomplish the goal, portfolio manager Kathleen Gaffney now has 14% of assets in stocks. Gaffney says the puny yields on Treasuries and other high-quality bonds don't compensate for the risk that rising rates could erode principal. Eaton Vance holds blue-chip dividend stocks, including Intel ( INTC) and E.I. du Pont ( DD). "Dividends can be a great source of stable income," says Gaffney. "You can find good companies at attractive valuations that are growing their dividends."

But not everyone is applauding the move away from bonds. Fran Kinniry, a principal of Vanguard Group, cautions it is extremely difficult to predict when rates will rise. Investors who try to time the next rate move may get it wrong. Instead of aiming to time the markets, most investors should develop long-term asset allocations and stick with them, Kinniry says. "Just because rates are low does not mean that they will go higher," she adds.

Kinniry concedes that bonds are likely to produce meager returns in the next decade because yields are small. But it is still worth holding fixed-income because it provides diversification. During the downturn of 2008, stocks of all kinds sank, but high-quality bonds produced solid returns.

To hold fixed-income assets that may be relatively resilient when rates rise, consider nontraditional bond funds, says Nadia Papagiannis, director of alternatives fund research for Morningstar. While they may hold high-quality bonds, the nontraditional funds can hedge by selling short, betting that bond prices will fall. "By adding a nontraditional fund, your portfolio would be more diversified, and there is a good chance that you will outperform if rates rise," Papagiannis says.

This year nontraditional funds have about broken even, while intermediate government funds lost 2.0% according to Morningstar. Among the top performers is JPMorgan Strategic Income Opportunities ( JSOAX), which has returned 2.5% this year. The fund holds a broad mix of securities, including Treasuries, foreign securities, and high-yield bonds. This year the portfolio managers have held big stakes in cash and short positions. That strategy provided a buffer during May when rates rose sharply. For the month, the fund stayed in the black, while the Barclays Capital U.S. Aggregate bond index lost 1.8%.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

More from Mutual Funds

Video: How to Select Mutual Funds in Your 401(k)

Video: How to Select Mutual Funds in Your 401(k)

Tax Tip: Uncle Sam Will Be Looking for Your Cryptocurrency Trades

Tax Tip: Uncle Sam Will Be Looking for Your Cryptocurrency Trades

Video: Jim Cramer Reacts to Novartis' Acquisition of AveXis

Video: Jim Cramer Reacts to Novartis' Acquisition of AveXis

U.S. Economy Added 103,000 Jobs in March, Missing Projections

U.S. Economy Added 103,000 Jobs in March, Missing Projections

U.S. Economy Seen Adding Jobs at 'Goldilocks' Pace For Stock Investors

U.S. Economy Seen Adding Jobs at 'Goldilocks' Pace For Stock Investors