Take your risk with stocks, not bonds
Some investors determine an asset allocation, like 70% stocks/30% bonds, and then try to maximize to maximize returns from each asset class. You can do this on the bond side by looking for higher-returning bonds. Corporate bonds or government-backed mortgage bonds, for instance, tend to return a more better than treasury bonds, the most boring (and safest) kid at the dance.
This is a bad idea.
Corporate bonds and junk bonds may generate higher returns than treasury bonds, but they do so at the price of higher risk. Of course, that’s what investing is all about, right - risk vs. reward? Yes, but you’re much better off taking your risk on the stock side than on the bond side.
Let’s break it down. If your 30% bond allocation is made up of corporate or high-yield bonds, your portfolio is going to have a higher risk and a higher return than if you own 30% “boring” bonds. In fact, it might perform like a 72%/28% portfolio, or even a 75%/25% portfolio.
This isn’t good if you want a 70%/30% portfolio. And if you actually want a 75%/25% portfolio, buy a 75%/25% portfolio! Stocks tend to reward risk better than bonds, so you’ll do better.
There are a few other reasons to avoid high-yield or corporate bonds. First, they tend to be more highly correlated with stocks, which means that they provide less diversification benefit. Second, they are exceedingly tax inefficient, which means that you really shouldn’t own them outside of a tax-advantaged account, like an IRA or 401K. So riskier bonds are less efficient with tax-advantaged space.
What should you buy for your bond allocation? Some - maybe half - of your bond allocation should be devoted to inflation-indexed bonds, like TIPS or I-Bonds. For the rest, check out the following types of funds.
- Short-term US treasuries (like FSBIX or VBISX). Low return, but the lowest risk you can find short of cash.
- Intermediate-term US treasuries (FIBIX or VBIIX). Slightly more return, and not a lot more risk. Some investors consider this the “sweet spot” of bonds.
- Total bond market (like VBMFX or FBIDX). This will include a mix of every type of bond, including a bit of the ones I’m recommending against, so the risk and return may be a little higher. But in a broad bond index fund, this doesn’t have a huge impact.
It doesn’t really matter which one you choose. When you retire, this will have a far smaller impact on your portfolio return most other decisions you make as an investor. So go with what’s available - if your 401K has one of these types, that’s fine. Just go with a low cost index fund; when you’re only dealing with a 1-3% return after inflation and taxes, a 1% expense ratio on an active fund is an absolute killer.
Remember: let stocks drive your returns, and use bonds to reduce volitility.
