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Fund Spy

Diversification: A Reason to Stay the Course With Your High-Quality Bond Fund

These funds prove their worth when markets turn rocky.

We often get questions about how investors should think about allocating their bond portfolios given that yields might be on the rise. Such fears are understandable. Rising yields mean losses for bond portfolios, at least in the short run, which is unsettling for those looking to meet a near-term goal.

Still, it's important not to lose sight of the important diversification benefits that bonds can offer. After all, none of us has a crystal ball. If the economy continues to chug along and inflationary pressures build, we could well see continued pressure on yields and losses for bond funds.

But, given the extended equity rally and the considerable uncertainty regarding trade and fiscal policy as well as broad geopolitical risk, stock prices could come under pressure. If they do, the insurance policy offered by bonds could come in handy.

Funds focused on government bonds have historically delivered the best diversification. The intermediate-term government Morningstar Category, which includes funds that devote at least 90% of assets to U.S. government and agency-backed bonds, featured a modestly negative correlation to the S&P 500 during the trailing 10-year period ended October 2017. That means that these funds tended not to move in lock step with equities. As the financial crisis rocked equity markets in 2008, for example, funds in that category returned 4.8% on average.

More recently, the S&P 500 fell 8.4% between August and September 2015, its biggest drawdown in the past five years. On average, funds in the intermediate-term government category posted a modest positive gain. Among Morningstar Medalists,  JPMorgan Government Bond (HLGAX) and  BlackRock U.S. Government Bond (PNIGX) both stand out for relatively low correlations to the equity markets during the 10-year period as well as more recently;  iShares MBS ETF (MBB) offers a similar profile for those in search of a cheap, passive option.

The intermediate-term bond category, meanwhile, shows a relatively low--if typically positive-- correlation to the equity markets, although there's a fair amount of variation. Correlations tend to be highest for corporate-heavy funds like  Loomis Sayles Investment Grade Bond (LSIIX) and  Dodge & Cox Income (DODIX), which have generated strong returns in healthy equity and credit markets thanks to large allocations to investment-grade and junk-rated corporates; Loomis Sayles Investment Grade Bond has even held modest positions in common stock. Medalists like  Vanguard Total Bond Market Index (VBTIX) and  Baird Aggregate Bond (BAGIX) that stick to investment-grade bonds and invest more heavily in U.S. Treasuries and government agency-backed debt have seen zero to modestly negative correlations during the trailing five-year period.

High-quality municipal bond funds have also proven their worth when it comes to offering diversification benefits.  Vanguard Intermediate-Term Tax-Exempt (VWITX),  Fidelity Tax-Free Bond (FTABX), and  T. Rowe Price Summit Municipal Intermediate (PRSMX) are all medalists that fit the bill here. Interestingly, even the high-yield municipal bond category, which is home to funds that court significant muni credit risk, has a zero correlation to equities for the trailing five-year period and a negative correlation during the previous three years.

That said, not all bond funds provide the same diversification benefit. High-yield bond funds, for example, invest in highly leveraged companies that tend to do well when the economy and corporate profits are strengthening, and some even hold the occasional common stock. As a result, they don't do as well during recessions or periods of credit market weakness, and they tend to be highly correlated with the equity markets, often suffering losses when stocks decline. That was true in 2008, when the average loss for funds in the high-yield bond category topped 25%. From August to September 2015, high-yield bond funds fell 4% on average. Other categories with hefty doses of credit risk--including the nontraditional bond and multisector groups--can also see their fortunes rise and fall along with equity funds. 

Looking at how funds have performed in the past doesn't tell you everything. Portfolios change over time, as do correlations between different asset classes. Indeed, during the worst of the credit crisis and the immediate rebound, correlations to equities were higher across a number of different categories. If inflation spikes unexpectedly and the Federal Reserve has difficulty taming it, or if real rates rise significantly, it could cause headaches for high-quality bond and equity portfolios. Still, it makes good sense to diversify your bets. For those with significant equity exposure, holding a high-quality bond fund is a good way to do just that. 

Sarah Bush has a position in the following securities mentioned above: VBTIX. Find out about Morningstar’s editorial policies.