Read the article "Get the Right Mix of Bonds", by Nellie S. Huang in Kiplinger's Personal Finance, 10/2020, and answer the following questions.

ARTICLE:

Get the Right Mix of Bonds

Match your goals with the appropriate fixed-income picks.

BY NELLIE S. HUANG

TIME WAS, RETIREES COULD GENERATE

enough income from safe-haven bond investments to cover living expenses. But those days are long gone, thanks to years of low interest rates. In Au- gust, the 10-year Treasury note yielded 0.57%, a far cry from the 2.60% yield it paid a decade ago. In re- sponse, many investors have taken on more risk by investing in bonds that fetch higher yields, or by shifting more of their portfolio into stocks.

In a changing market, it's time to remember why we hold bonds in the first place. They should play four key roles in a diversified portfolio. Some bonds provide a counterbalance to your stock holdings by holding steady when stock prices plummet. Others act as safety nets, preserving money you need to tap soon. Some debt still generates decent income, despite low rates. Finally, though a rise in con- sumer prices for goods and services may not be an immediate threat, some bonds hedge against inflation, too.

No single type of bond, or bond

fund, can fill all four roles. "A bond that provides income may not be the best choice to provide preservation of capital," says Ekta Patel, a director at Altfest Personal Wealth Management. That makes the mix of bonds you hold important. Understanding what your portfolio needs most and choosing

26 KIPLINGER'S PERSONAL FINANCE 10/2020

funds best suited for those needs is the first step toward building a bond portfolio that's right for you.

Set your priorities. You may have to prioritize certain portfolio objectives depending on the state of the market overall. Back in the day, when interest rates were higher, generating income was the primary objective in bond portfolios, and protecting that income from the insidious erosion of infla- tion was a close second. These days, income generation takes a backseat

to bonds' role as diversification from stocks. "In a low-rate, low-inflation environment," says Patel, "how you use bonds and which types of bonds you use have to change."

A lot depends, too, on your age or time horizon. If you're younger and holding 80% of your portfolio in stocks, stick with high-quality debt that zigs when stocks zag. Older in- vestors with 80% in bonds and 20%

in stocks might skew a portion of their fixed-income portfolio toward securi- ties that can generate measurable in- come, even if it entails a bit of risk.

On the following pages, we'll walk you through the four objectives that bonds should meet in a portfolio and show you how to put the pieces to- gether in model portfolios. Returns are through August 7.

ILLUSTRATION BY DAN PAG

DIVERSIFY FROM STOCKS

When stock prices fall, the bonds you hold as ballast should rise in value, or at least stay steady. Classic holdings in this category are U.S. Treasuries and other government-backed debt,

such as agency mortgage-backed secu- rities. High-quality corporate debt issued by firms with credit ratings of triple-A to triple-Bcan play a role, too.

Bonds to avoid: High-yield corporate debt (IOUs issued by companies with credit ratings from double-B down

to single-C), bank loans, emerging- markets bonds and preferred stocks. The prices of these securities tend to move in step with stocks, which is counter to the objective.

Quality matters in this core part of your portfolio. In bond-speak, high- quality issues are liquidthey can be sold quickly in volatile markets without causing a huge drop in price. "The value of a true core bond fund is that when stocks crater, you can sell shares in it to buy more stocks as a way to rebalance," says Luke Farrell, fixed income invest- ment director at the management firm Capital Group, which runs the Ameri- can Funds mutual funds.

Our favorite funds for providing a counterbalance to stocks fall in the intermediate core bond fund category. These funds hold mostly Treasuries, government-guaranteed mortgage- backed securities and high-quality corporate debt. Actively managed

VANGUARD CORE BOND (SYMBOL VCORX, EX-

PENSE RATIO 0.25%) tilts mostly toward mortgage-backed securities. That has helped the fund beat its benchmark, the Bloomberg Barclays U.S. Aggre- gate Bond index, over the past one and three years. Core Bond yields 1.20%.

FIDELITY INVESTMENT GRADE BOND

(FBNDX, 0.45%) is a good complement to the Vanguard fund. It has a hefty slug of assets45%in corporate debt. The fund's 6.4% annualized three-year re- turn beat 97% of its peers. But invest- ment-grade corporate debt suffered

in the March bond sell-off. As a result, the fund lost 7.4% during that draw- down, compared with a 5.7% drop in

the Agg index. The fund yields 1.40%.

Fans of exchange-traded funds should look at VANGUARD INTERMEDIATE- TERM BOND (BIV, 0.05%). It is index-

basedpassively managed funds are not our first choice for this corner of your portfoliobut the fund has beaten the Agg index in eight of the past 10 calendar years (and so far in

2020). More than half of the portfolio holds government debt, and much of the rest is in high-grade corporate bonds. The ETF yields 1.04%.

Aggressive investors who have longer time horizonsmore than

10 years before they need the money, saycan perk up their core holdings with a sliver in an intermediate-term, core-plus fund. The plus distinction means these funds have more latitude to invest in junkier debt than tradi- tional core bond funds. But they also hold safe-haven government IOUs.

METROPOLITAN WEST TOTAL RETURN BOND

(MWTRX, 0.67%) is a core-plus bond fund and a member of the Kiplinger 25, the list of our favorite no-load funds. The managers are bargain-minded, patient and disciplined. The fund is currently defensively positioned, with 62% of

its assets in triple-A-rated debt. (Less than 7% is invested in junk-rated IOUs.) Over the past three years, the fund's annualized 5.8% return beat 76% of its core-plus bond fund peers. It yields 1.21%.

Mortgage bonds fill DOUBLELINE TOTAL RETURN BOND (DLTNX, 0.73%), another Kip

25 member. The managers seek to bal- ance the twin risks of issuer defaults and interest rate swings (when inter- est rates rise, bond prices fall and

vice versa). At last report, the fund held a 45% stake in government- agency mortgage-backed securities, which carry no default risk but a lot of interest rate risk, and 35% of the port- folio in non-agency mortgage-backed bonds, which have little interest rate risk but high default risk. Recent re- turns have suffered because the fund doesn't hold much in corporate bonds, which have been hot lately. But over the past decade, this low-volatility

10/2020 KIPLINGER'S PERSONAL FINANCE 27

INVESTING

strategy has outpaced its peers and the Agg index. It yields 2.85%.

PIMCO ACTIVE BOND (BOND, 0.73%) is also

worth a look. As its name implies, it's actively managedemphasis on active in the current market, says comanager David Braun. "It is a bond picker's market right now," he says. During the bond sell-off in March, the managers loaded up on agency mortgage-backed securities and investment-grade cor- porate debt. The fund yields 1.79%.

GENERATE INCOME

Reset your expectations for how much income your bonds can generate. "The idea that you can pick a yield and get it is no longer realistic," says Gene Tannuzzo, deputy global head of fixed income at Columbia Threadneedle In- vestments. Prior to the financial crisis

of 2007-09, for instance, 10-year Trea- suries yielded nearly 5%. "To earn that today," says Tannuzzo, "you'd have to put all of your portfolio in high-yield bonds." And that is too risky a move.

That said, with a careful blend of bond funds, you can eke out a yield of 2% to 3% with only a bit of added risk. Lean on high-quality, investment- grade corporate bondsthose rated between triple-A and triple-Bwhich currently yield 1.40% to 2.29%. That sounds low, but it's better than what you'll earn on cash, which is nothing. "Yield is relative," says Paul Zemsky, chief investment officer of multi-asset strategies and solutions at Voya. In addition to investing in high-quality corporates, you can boost incomein small doseswith a multisector bond fund or a high-yield bond fund.

FIDELITY CORPORATE BOND (FCBFX, 0.45%)

has returned 7.4% annualized over the past three years, which beats 83% of all investment-grade corporate bond funds. It outpaced its peers on a risk- adjusted basis, too, over the past one, three, five and 10 years. The fund yields 1.54%. The trio that run Corporate Bond also manage the active ETF FIDELITY CORPORATE BOND (FCOR). The ETF sports

a slightly lower expense ratio of 0.36% and a higher yield of 1.84%.

A multisector bond fund floats be- tween sectors to capitalize on the best opportunities. PIMCO INCOME (PONAX, 1.45%) is designed to deliver a steady income stream. It currently holds mostly securitized debt (mortgage- backed and asset-backed securities not guaranteed by the U.S. govern- ment), emerging-markets debt and high-yield corporate IOUs. But not all of the fund is junky. Income also holds a small slug of investment-grade credit and government bonds.

Given its preferred milieu, however,

the fund's performance was rough during the March bond sell-off, and it lost nearly 9% (compared with a 5.7% loss in the Agg index). But Income, which yields 2.48%, has been a stal- wart in the past. The fund levies a front-end sales charge, but at E*Trade, Fidelity, Schwab and TD Ameritrade, you can buy shares without a load or

a transaction fee.

High-yield debt, in small doses, can spice up your income exposure. There are good opportunities, says Voya's Zemsky, but you must be selective.

"A high-yield index fund is not a good idea," he says. "Buy one that's run by a seasoned manager who is skilled at picking good credit." VANGUARD HIGH YIELD CORPORATE (VWHEX, 0.23%), a mem-

ber of the Kip 25, has long won our favor. Manager Michael Hong keeps risk at bay by focusing on debt rated double-B, the highest-quality junk- bond rating. It yields 4.12%.

PRESERVE CAPITAL

This strategy strives to prevent losses and is usually reserved for money you're going to need within three years or so. High-quality short-term bond funds are the best bets for this corner of your bond portfolio. Risk of default is negligible. These funds are also less interest-rate sensitive, which can provide a hedge against rising rates. Though few bond experts ex- pect interest rates to rise in the near term, rates are historically low, so the risk of a move higher is greater.

VANGUARD SHORT-TERM BOND ETF (BSV,

0.05%) tracks an index that includes a mix of investment-grade government, corporate and international bonds de- nominated in U.S. dollars. Maturities span one to five years. The ETF has an average credit quality of double-A and its performance is steady. Over

the past decade, the ETF been roughly half as volatile as the broad bond in- dex, Bloomberg Barclays U.S. Aggre- gate Bond. And over the past three years, Short-Term Bond ETF has re- turned 3.4% annualized. It yields 0.38%. A mutual fund version of the fund, symbol VBIRX, charges 0.07% in fees and yields 0.36%.

An even tamer bet is ISHARES ULTRA

SHORT-TERM BOND (ICSH, 0.08%). This ac-

tively managed ETF holds a mix of cash and corporate debt with one- to three-year maturities. It held up well when the bond market plunged in March, losing less than 1%, compared with a 5.7% deficit in the Agg index. (Vanguard Short-Term Bond surren- dered 1.7%.) Plus, Ultra Short-Term Bond's 2.4% one-year return beats the yield of most money market funds.

HEDGE AGAINST INFLATION

We're not worried about inflation for now. Kiplinger expects 1.1% inflation for 2020, below the 2.3% rate recorded in 2019. But the Fed's easy-money policies mean high inflation is a great "likelihood" in the future, says SamLau, a strategic commodity portfolio manager with DoubleLine.

Treasury inflation-protected securi- ties, or TIPS, act as an insurance pol- icy against rising prices. They pay a fixed coupon rate on top of principal that is adjusted for inflation and they come with the full faith and credit

of the U.S. government. You can buy TIPS directly from Uncle Sam (at www.treasurydirect.gov) or through your brokerage firm. Holding the ac- tual bond ensures you'll get your in- flation-adjusted principal back, plus the bond's coupon rate, or interest,

over time. With a negative 1.04% yield currently, that means you'll get infla- tion minus the negative yield.

We also like VANGUARD INFLATION- PROTECTED SECURITIES (VIPSX, 0.20%). The

actively managed fund invests only in

U.S. inflation-protected bondsunlike some other offerings in this category, which goose returns with investments in higher-risk assets, including com- modities and high-yield bonds. That's one reason this solid fund's three- and five-year annualized returns rank just above average compared with its peers' returns. Like actual TIPS, Van- guard Inflation-Protected Securities has a negative 1.10% yield. SCHWABUS TIPS (SCHP, 0.05%) is an index-based exchange-traded fund with a super- low feean advantage over its typical peer, which charges 0.73%. The ETF has outpaced its peers in eight of the past nine full calendar years. The catch is its negative 0.03% yield.

TIPS matter more for investors who are already retired than for those who are early in their careers. The typical target-date fund for those already re- tired allocates nearly 10% of assets to TIPS. For those just beginning their working life, target-date funds usually have a fraction of 1% of assets in TIPS. For investors still working but nearing retirement, an allotment of 2% to 5% is more than enough in your bond port- folio. If inflation were to spike, how- ever, we might change our tune.