How to Build the Bond Core of Your Portfolio

Hi, I’m Susan Dziubinski, co-host of The Morning Filter podcast. On a recent episode, I sat down with Morningstar’s director of personal finance and retirement planning Christine Benz to talk about portfolio planning, international stock investing, bonds, and more. Our conversation took place on April 8. Here’s an excerpt.

The Best Bond Funds for the Core of Your Portfolio

Susan Dziubinski: Great. Let’s pivot over to bonds and bond funds, another topic of interest to The Morning Filter’s audience and another asset class that you think is really essential, as part of even a minimalist portfolio. You often say on Morningstar.com, and in other conversations we’ve had, that you feel that intermediate core bond funds, and maybe intermediate core-plus bond funds, are the best for most investors for that bond portion of their portfolio. Talk a little bit about why.

Christine Benz: Right. This is not the return engine of your portfolio. In fact, I was looking at the total bond market over the past 15 years, like a 3% return, and surely inflation has gobbled up a portion of that return. But you’re looking for something that is going to be ballast for your equity portfolio in that equity market shock, whether it’s March of 2020 or some recessionary environment when stocks aren’t always bad, but often they aren’t great. That high-quality fixed-income sleeve is important. Here, I would look to the core intermediate-term bond, maybe what’s called a core-plus intermediate-term bond that has some latitude to dabble in some higher-yielding, lower-quality fixed-income types. Those would be the core of someone’s fixed-income portfolio. If someone’s just kind of waking up and saying, “Hey, I’m 57, and I probably should get some of this stuff.” I’d start there.

Dziubinski: You mentioned that core-plus bond funds can dabble in lower quality, but what do you think of, say, multisector bond funds, which probably do more than dabble in lower quality, or let’s say global bond funds?

Benz: Multisector is going to be a grab bag of high-yield or junk bonds. They might own some non-dollar-denominated bonds. They might even own some stock some of the time. Those, I would relegate to that supporting player role in a portfolio, where that’s not my main bond holding. It’s going to perform probably more in sympathy with the equity market; when equities are down, it probably will hold up better, but may not look that great. I wouldn’t want to use it to supplant high-quality fixed income, even though the yield may be higher, and the long-term returns might look better. That’s a risk-on asset that I would use to augment the high-quality fixed-income assets.

Do You Need a Global Bond Fund?

Dziubinski: What about global bonds?

Benz: I think there’s a case for them. I haven’t included any dedicated global bonds in the portfolio, in part because by the time you include a currency-hedged product, the returns tend not to be that different from the US market. I don’t know that I’d go out of my way to add a dedicated global fixed-income fund.

Dziubinski: And, you are trying to keep these simple. You said there are other things you’ve left on the cutting room floor, and this is just one of those things, I guess, right?

Benz: Yes. I look at a product like Vanguard’s target-date series, and they do, very much, include that component of global bonds. I think it’s a reasonable thing to add, but in the interest of not having so many holdings, I’ve excluded it.

Should You Be Tactical with Bonds?

Dziubinski: We’ve been in an environment where interest rates have stayed higher for a little bit longer than people have expected. You said that’s good for investors for bonds because it’s sort of predictive of what your return may be going forward. Let’s say a year from now, interest rates are coming down, and investors want to start stretching for yield. Maybe they want to consider some lower-quality credits, or they want to extend their durations. What do you think of those tactical moves with your bond sleeve?

Benz: You could do it around the margins, but the thing I would keep in mind is to remember why yields are going down. It’s often because there’s some concern about the economy softening. The Federal Reserve is a little bit more accommodative in periods like that, where they want to make sure that the economy stays strong or doesn’t weaken. Oftentimes, when you’re chasing yield in an environment like that, you are leaning into risk at a time when you might not want to be taking it. All of those security types, or especially the higher-yielding, lower-quality fixed-income types, will tend to be vulnerable in those weakening economic environments. I would do it around the margins of a portfolio to the extent that I did that at all, and stay mindful of economic conditions.

Who Should Own Inflation-Protected Bonds?

Dziubinski: You did mention inflation-protected bonds earlier in our conversation, specifically for those in retirement as part of the Bucket strategy. Talk a little bit about what role they play and why you think that’s very important for retirees.

Benz: When you’re working, you typically are earning some sort of cost-of-living adjustment in your paycheck. You probably don’t need to go out of your way to include inflation-protected bonds in your portfolio. You’re not spending from it yet, and stocks will be your best defense against inflation. Maybe you include a couple of categories like commodities, precious metals, or something like that. When you’re in retirement, it’s a different ball game because you’re extracting at least some of your cash flows from your portfolio, and some of those safer investments—which are important to own, like cash and bonds—will be vulnerable to inflation. That’s where dedicating a component of the portfolio to inflation-protected bonds can be really valuable because those bonds give you an inflation adjustment to help keep your purchasing power whole. That’s one reason why all of my Bucket portfolios do include a component of inflation-protected bonds.

The fund I’ve used in a lot of the portfolios is Vanguard’s Short-Term Inflation-Protected Securities VTAPX. The reason I like that short-term product is that it tends not to pick up on a lot of the interest rate-related noise that can come along with intermediate-term bonds. It’s more or less a pure reflection of inflation, so that’s a nice fund to have in the toolkit. No matter where retirees are investing, I think having that inflation-protected bond exposure is important. They might also get it from I bonds. The issue with I bonds is that the purchase constraints limit you from being able to build a significant bulwark against inflation, but if you do so over a number of years, you should be able to get a nice defense going in I bonds as well.

Core Bond Funds to Consider

Dziubinski: Lastly, on bonds, Christine, what are some of the other core bond funds or core bond-plus funds that find their way into your model portfolios?

Benz: One that I’ve used in a number of the portfolios, Susan, is an iShares fund. It’s called iShares Core Universal USD Bond IUSB. One reason I like it is that it does include a little dash of lower-quality bond exposure. It’s more holistic than some of the other total bond market indexes. Certainly, for investors who want to use the total bond market index, I think that’s a fine core fixed-income holding. We also use Fidelity Total Bond FTBFX in a number of the portfolios. That sounds like it’s an index fund, but it’s an active fund that our analysts like a lot. Fidelity Short-Term Bond FSHBX is another active fund that our analysts like. We’ve also used Fidelity’s muni funds in a number of the portfolios, as well as Vanguard’s muni funds. Vanguard Short-Term Bond Index VBIRX is another fund that we like and that I have used in a number of these portfolios.

Watch Christine’s full appearance on The Morning Filter podcast.