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This article should be useful to anyone constructing or reviewing a fixed-income portfolio. It describes the basic asset classes, provides selection criteria for bond funds, examines several selections closely and contains comprehensive resources concerning alternatives.

My dividend growth portfolio is 65% of my asset allocation. Here we're looking at the other 35%, the fixed-income portion. While I am a strong advocate of dividend growth investing to provide increasing income that will outpace inflation, I believe it is advantageous to own a balanced portfolio of stocks and bonds. This article demonstrates how various stock and bond allocations affect risk and reward. It describes measurements used in bond fund selection, including duration, and different measures of yield. The summary asks questions to assist you in determining your best course of action.

The Equity Portion of Your Portfolio

When you buy a stock, you become a part owner of a corporation. Investopedia's definition states:

In terms of investment strategies, equity (stock) is one of the principal asset classes. The other two are fixed-income (bonds) and cash/cash-equivalents. These are used in asset allocation planning to structure a desired risk and return profile for an investor's portfolio.

Usually the rights of ownership include participation in the election of the Board of Directors, participation by voting on key issues at annual meetings, and a proportional share in the dividends paid by the company. In addition, you enjoy the benefits of the increasing wealth of the company, including increased share prices.

Check out my stock portfolio article, "Constructing Your 2012 Dividend Growth Portfolio, Dependable Yield With Managed Risk And Volatility."

Fixed Income Securities

When you purchase a bond, you become a lender to the corporation or to the government issuing the bond. They owe you the amount of the bond payable to you at maturity and pay you interest in the meantime. If you do not wish to hold a bond to maturity you can sell it the secondary market. As a creditor, you have a higher claim on the assets of the company than the stockholders have, but do not share in the profits of the company. You get the agreed upon interest, a steady stream of equal payments, usually paid to you twice a year. There is generally less risk in owning bonds than in owning stocks, but this comes at the cost of a lower return.

Why own bonds? Bonds produce a reliable and even flow of fixed income. A typical investment portfolio has a mix of stocks and bonds. Bonds are the more conservative of the two assets; that is, they are much less volatile and there is less risk of a fast loss of capital. In addition, bonds often move in the opposite direction of stocks. One asset class moves up, the other moves down. Stocks, however, usually produce higher returns over the long run.

Young investors allocate their investable assets into stock; the reasoning is that the ups and downs even out over a lifetime of investing. Older investors usually move toward a heavier bond weighting, as their time to recover from fickle markets is shorter. A traditional way of figuring how much an investor should allocate to stocks is to subtract his or her age from 100. The resulting number is the amount, as a percentage of total investable assets, which goes into stocks. For example, a 20 year old would have 80% in stocks, 20% in bonds, while a 50 year old would have 50% in each. A 70 year old would only have 30% in stocks and 70% in bonds. There are many variations on this theme, using 120 instead of 100 as the base to subtract from, or in concert with consideration of age, determination of the risk tolerance of the investor. For the risk averse, bonds are a traditional haven.

Stock and bond returns for the 20-year period leading up to the Great Recession are shown below. While stocks had some years with dramatic gains, up to 37.0%, there were also dramatic losses. Meanwhile, bonds plugged along at a more even pace. The conventional wisdom during that era and continuing today is that the best of both worlds is available with a mixture of stocks and bonds, risk and age adjusted. An annual rebalancing to the target allocation effectively applies gains from the in-favor asset class to purchase the other class at a cyclically lower price.

Click to enlarge all images.

I have always owned bonds in my total portfolio because of the stability and for the steady income stream. The dampening effect that bonds, and bond funds, have on the total volatility of my investments is significant. I like the knowledge that if the stock market has a 20% correction, my total portfolio is likely to go down much less than that. Of course, there are degrees of risk and reward in both stocks and bonds; a prudent selection of securities is always necessary. In addition, there are times when there are great opportunities in equities, and lesser opportunities in bonds. This is one of those times. I should note that my 65% stock, 35% bond portfolio is the inverse of the traditional ratio for a person of retirement age.

There is no right or wrong allocation. Mine is suitable for my risk tolerance, my understanding of interest rate movements and inflation, and is weighted toward stocks. My belief is that with current low bond yields, many attributes of bonds can be found in blue-chip dividend-paying stocks. However, I do not advocate holding over 80% in either asset class.

On its investment site, Vanguard, a leading fund company, makes tools available to help you assess risk and select your mix of stock and bonds. The images below show the expected risks and returns of a 100% stock portfolio, a balanced portfolio of 60% stocks and 40% bonds, and a 100% bond portfolio.

The expectation is for a 5.6% average return when one is 100% invested in bonds, based on the past 86 years of market history. Your worst year might be an 8.1% loss, and you will be up 73 out of 86 years. On the other hand, if you invest 100% in stocks you might expect to average a 9.9% return, over time. However, in the worst year in the period you could be down as much as 43%. In addition, you may expect to have a loss in almost one out of three years with 100% in stock.

Most investors, over the past 25 years or so, have chosen to invest in a mix of stocks and bonds. For the bond investor, a 20% allocation to stocks increases the average return to 6.3% and gives added protection against inflation. For the stock investor, an allocation of 80% in stocks and 20% in bonds adds a great stabilizing effect to the portfolio, which still provides a 9.4% return.

Holdings of Bonds and Bond Funds

The bonds (individual bonds and bond funds) I own were chosen over time, and during that time interest rates declined but now are at an extreme low and will certainly rise. Therefore, there was one attribute I took careful notice of when selecting these fixed-income investments. That is duration. The Investopedia definition states:

The duration indicator addresses a security's change in value corresponding to interest rate changes. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. If interest rates rise 1% a bond with a duration of 5 years will decline 5% in value. If a bond has a duration of 2, if will lose 2% of its value.

Even the highest rated bonds and bond funds are not risk free. Investors need to be aware of two main risks that can affect a bond's investment value: credit risk (default) and interest rate risk. Interest rate changes are primarily due to the actions of the central bank. S&P, Moody's and Fitch rate the credit risk of bond issuers. Fund companies publish the percentage of their holdings that are in each category: AAA, AA, A, BBB, BB, and so on.

The yield is also a critical measurement. Fund sites and reporting services are inconsistent in the way they calculate and report yields. Unfortunately, there is no single source for end-of-month 30-day SEC yields. The SEC yields given in this article are from the funds' websites as of June 6, 2012. Shown also are the yields as reported by Morningstar, which are quoted in trailing returns. SEC yields are more forward-looking, as they focus on only the last 30 days. However, I do not believe that you can expect to receive over 7% on TIPS, as shown below. Short time periods do not always reflect longer ones or trends.

The Treasury Inflation Protected Securities Bond Fund (TIP) seeks results that correspond generally to the price and yield performance of the inflation-protected sector of the United States Treasury market as defined by the Barclays Capital U.S. Treasury Inflation Protected Securities Index (the Index). The Index includes all publicly issued, the United States Treasury inflation-protected securities that have at least one year remaining to maturity, are rated investment grade and have $250 million or more of outstanding face value. The Fund generally invests at least 90% of its assets in the bonds of the Index. As inflation increases, the bonds pay a higher dividend.

The Templeton Global Bond Fund (TEGBX) is arguably the best in class, especially if one can tolerate a couple of recent bad years. It holds top positions for five-year and 10-year performance, outpacing all rivals. After a difficult 2011, it appears as if it's back on track. Morningstar currently rates this as a four-star fund and gives it its Gold Shield. Lipper rates it as a five, its highest rating.

The Fund seeks current income and capital appreciation by investing at least 80% of its net assets in bonds of governments and government agencies located anywhere in the world. The fund manager says, "We search the world for investment opportunities in currencies, interest rates and sovereign credit that can offer attractive potential returns and additional portfolio diversification." Michael Hasenstab, PhD, joined Franklin Templeton in 1995 and has managed the fund since 2001.

The fund has moved to shorter duration bonds, and has avoided the European crisis for the most part. They have significant investments in South Korea, Indonesia, Mexico and Poland. The Fund provides an excellent yield; however, the expense ratio is 1.30%. I have held this for many years and am very satisfied with the strategy and the performance. A five-year chart from U.S. News follows. Below that are alternate international bond fund offerings (source: Minyanville).

The Vanguard Investment Grade Short Term Bond Fund (VFSUX) was introduced in 1982. I have held it in my IRA since 1986. I use it like a money market fund to hold temporary and short-term cash, and have no cash position otherwise. Transfer of funds to other accounts and redemption is easily done online or by phone. In addition, a check writing option is available.

This fund gives investors exposure investment-grade bonds with short-term maturities and a short average duration. Although short-term bond funds tend to have a higher yield than money market funds, the tradeoff is share price fluctuates. Additionally, increases in interest rates can cause the prices of the bonds in the portfolio, and the fund's share price, to decrease. Because the duration is relatively short, fluctuations due to interest rate changes are small.

The Admiral version of the fund has a $50,000 minimum. The Investors version (VFSIX) has a minimum of only $3,000 and the only difference is an annual expense cost of 0.21% instead of the incredibly low 0.11% of the Admiral version.

The Vanguard GNMA Fund (VFIJX) offers the safety of U.S. government backed securities, a respectable yield, short duration and incredibly low expenses.

This bond fund specializes in government mortgage-backed securities, primarily GNMA securities, backed by the full faith and credit of the U.S. government. When mortgage refinance activity is high, the yield on the fund is likely to decrease. Investors with a medium-term time horizon and a goal of monthly income may wish to consider the fund. Like the Short Term Bond Fund, there are both Admiral and Investor shares.

Individual Bonds

A popular and efficient way of investing in bonds is to create a ladder with different maturities. In recent years, I have chosen to buy bond funds instead. I still own bonds that mature in 2015 and 2016, and it is my intention to hold them to maturity. The average rate of interest is 5.5%.

High-Yield Bonds

As the old saying goes, "More money has been lost chasing high yield than at the point of a gun." For those who wish to assume more risk in hopes for higher returns, the SPDR Barclays Capital High Yield Bond ETF (JNK) is one choice and the other is the iShares iBoxx High Yield Corp Bond (HYG). Yields are in the 7% area and durations around five years. An alternative might be PowerShares Fundamental High Yield Corp. Bond (PHB), which has a yield of 5.5% and duration of four years. The distinguishing factor is that it holds no bonds lower than those rated B. I have no investments in this category.

Preferred Stock Fund (PFF)

Preferred stock is a fixed income investment and often grouped with bond holdings. The iShares S&P U.S. Preferred Stock Index Fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the S&P U.S. Preferred Stock Index. About 24% of the holdings are in the banking sector; other financial stocks account for 46%. The fund is a stable source of dividends.

Additional ETF Resources

Bond holdings from different sectors of the bond universe add diversification and reduce the volatility of the total bond portfolio. Here are some additional ETF choices in various categories of bond funds.

Summary

Fixed-income holdings supplement a dividend growth portfolio to provide a dependable retirement income with stability and lowered risk of capital loss. As interest rates are expected to rise, you may wish to underweight bonds while keeping the durations short. A bond allocation is important, but dividend growth stocks remain the primary engine to power your retirement.

Some advocate a current position of 100% stocks, others believe that a move to shorter durations or a flight from bonds based on rising interest rates is premature. Differences of opinion are healthy in investing; they provide an opportunity for clearer articulation of beliefs and stimulus for deeper analysis and reflection. I am interested in reader comments on allocations and expected interest rate increases.

Questions to Ask to Determine Your Course of Action

  • How much will you allocate to stocks, and how much to bonds?
  • How much of this will be international debt?
  • How many bond funds do you need to own?
  • How much credit risk are you willing to assume?
  • How much market risk/interest rate risk do you want to take?
  • How much yield are you willing to give up for added safety?

We all struggle with these questions.

Disclosure: I am long TIP, PFF. I also hold TEGBX, VFSUX, VFIJX, which are mutual funds.

Source: A Bond Allocation For Your Dividend Growth Portfolio