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The Short Answer

What to Do with Poorly Performing Bond Funds

Keep them, but consider rebalancing gently into corporates and convertibles.

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Bonds are not perfect investments. They give a fixed rate of return that often barely keeps up with inflation over the longer haul, and they can go down if interest rates go up. They tend to hold up when stocks decline, but even that isn't a bankable certainty. High-quality corporate bonds, for example, may not hold up in a stock market decline or amid financial panic if their prices have been previously bid up by yield-hungry investors in a low-yield environment.

This last phenomenon is exactly what has happened recently. As painful as it has been to see the S&P 500 Index drop nearly 40% this year, some investors have suffered inordinately because the non-stock parts of their portfolios haven't held up well either. Basically, most bond categories except for U.S. Treasuries (where investors flee when gripped by fear) are also off for the year too, making this an extremely treacherous market for even the most well-diversified investors. The Morningstar intermediate-term bond-fund category, for example, is down 6.5% for 2008 through late October, while the Morningstar Intermediate Corporate Bond Index is down 8.7%.

Still, everyone needs some bonds in their portfolio because they often do hold up well when stocks don't. Usually, bonds provide ballast in your portfolio, helping you stick with your stocks when the going gets tough. This was certainly the case in the stock market decline from 2000 through 2002, when bonds held up splendidly and saved well-diversified investors a great deal of pain. Bonds must be part of every investor's asset-allocation strategy--and given how volatile stocks are, they should be a major part of most retirees' strategies.

Moreover, corporate bonds appear cheap now to many managers we've spoken to.

What Now?
Bond aficionados like to talk about "spreads" or the difference between the yields on different kinds of bonds. Typically, they'll talk about the spread between Treasuries and high-quality corporates or Treasuries and high-yield (low-quality or "junk") corporates. In recent years, spreads have been narrow, to say the least. So, if you've owned corporate bonds over the past few years, they've probably paid you only a little bit more than Treasuries.

Now, however, investors are demanding to be paid more for the risk they're taking by owning corporate bonds, as the fear increases that a recession may hamper firms from making good on money investors have loaned them. Because investors can't change the coupons or prearranged fixed payments on existing corporate bonds, investors are selling out of them or lowering the prices. This makes the fixed yield a larger percentage of the new lower price.

However, precisely because investors are selling out of corporates and lowering prices, we think it's time to rebalance the bond piece of your portfolio by shifting a bit out of Treasuries and into corporates.

The good news is that if you're in a good intermediate bond fund, which should be the core of most bond portfolios, you can leave this gentle switching to the manager. Intermediate bond funds generally have a mixture of governments, mortgages, and corporates. If you're looking for a good core bond fund that holds a mixture of a variety of bonds, start with our Analyst Picks list. Consider fees, which are hugely important for bonds, manager tenure, and how the fund generally deals with the two main types of bond risk: interest-rate risk and credit risk. Our analyst reports will have plenty to say about those things.

More hands-on investors may consider shifting some of their assets themselves into a corporate bond fund or exchange-traded fund. We're not talking major moves here--hands-on investors can consider moving a small piece of their bond portfolio (say 5%-10%) into a coroporate fund.

One good option might be iShares Investment Grade Corporate Bond Fund (LQD), a basket of highly rated bonds which is now yielding nearly 8% and has a 0.15% expense ratio. This basket includes issues from global corporate titans such as  Johnson & Johnson (JNJ),  Astrazeneca (AZN), and Warren Buffett's  Berkshire Hathaway (BRK.B). So, if the U.S. government will pay you 4% for a 10-year loan right now, it could make sense to lend your money to these corporate giants who would pay you more. Sure, they're not as safe as the government--no entity is--but they're not exactly fly-by-night operations either. Consider that you pay a stock brokerage commission when you purchase an ETF.

Another place to gain access to corporate bonds is  Loomis Sayles Bond (LSBRX), which is an Analyst Pick in the multisector bond category and is managed by former Morningstar Fixed-Income Manager of the Year Dan Fuss. Fuss has argued in an interview ( ) with my colleague analyst Eric Jacobson that he hasn't seen corporate bonds this cheap since the 1970s. As a multisector fund, this fund will resemble an intermediate fund in some ways, but it has the capability to take on more credit risk. In other words, Fuss can buy a lot more high-yield or junk bonds and also emerging-markets bonds when he thinks the time is right, so this fund has a riskier profile than a plain intermediate fund.

Finally, convertible bonds haven't been this cheap in anyone's recent memory, as convertible bond fund managers impressed upon Morningstar mutual fund analysts in a recent round of interviews. Convertible bonds are corporate bonds with options attached to them, giving the holder the opportunity to convert to stock at a particular price. Therefore, they have some bondlike characteristics and some stocklike characteristics. The reason why they're arguably cheap now is because many hedge funds have been forced to sell them. The hedge funds practice a fancy strategy called convertible arbitrage, whereby they buy the convertible bonds of a company and short (bet on a decline of) the common stock of the same company. They borrow money to magnify their returns, which, because of the credit crisis, they're now being forced to pay back. Consequently, they have to sell the convertibles, many of which are yielding in the 7%-8% range, despite investment-grade credit ratings in some cases. One of our favorite funds in the convertible bond category is  Vanguard Convertible Securities (VCVSX), which has been pummeled this year, but which we also think is poised for recovery.

Convertible funds don't always hold the highest quality bonds, so they should be used in moderation--5%-10% of a portfolio in these instruments should be plenty for most investors.

Additionally, corporate bonds, both the plain ones and the convertibles, should be held in tax-advantaged accounts as much as possible, because their interest is taxed as ordinary income.

John Coumarianos does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.