How To Use Bonds To Reduce Investment Risk

The unglamorous bond can actually be an exciting part of a co-ordinated investment strategy, and allow you to offset investment risk in other parts of your portfolio, due to their counter-cyclical relationship with other investment vehicles, particularly shares.

For most investors, bonds are just one thing - ballast. Bonds can work well for income seekers, and, in the hands of an adept speculator, they can beat the stock market for long stretches. But this is not how most investors use them. Most buy and hold, rather than speculating.

There is a better way to get extra value from your bond investment. Bonds help in keeping a stock-focused portfolio sturdy -- steadily, predictably heading in the right direction for long-term returns.

After their moment in the sun during the 80s, bonds were neglected during the 1990s bull market in stocks. Investors parked ever more of their assets in equities, afraid to miss out on the exponential growth. But when the market tanked in 2000, stocks-only portfolios shattered. Better-diversified accounts, however, enjoyed much of the stellar performance without the crash landing.

It's All About The Ratio

The first fixed-income question for most investors is, what's the right ratio of bonds to stocks?

Michael Holland, manager of the Holland Balanced Fund, strongly advocates a 60/40 ratio of stocks to bond for most investors. With this ratio, investors can generally gain 80% of the stock market's long-run return but with only a moderate level of volatility along the way.

Holland's fund is set up with this ratio -- but it wouldn't be hard to copy it for yourself. It's split almost exactly 60/40, with the 60% held in stocks spread across about 20 blue chips. The bond portion is almost exclusively in Treasuries, the rock-solid bonds issued by the U.S. government.

A $10,000 deposit in Holland's fund when it started in April 1997 was worth $11,711 in January 2003. An identical investment in the Vanguard 500 Index fund would have been worth $12,162. In 2001, when the S&P 500 index plummeted 11.1%, Holland's balanced fund lost just 0.2% of its value.

Interested in even more security than that? The minimum-risk allocation is probably 80% fixed-income, 20% stock, according to Alan Gayle, senior investment strategist for Trusco Capital Management. In his view, a 100% bond allocation is never a good idea, even for the most risk-averse investor, because bonds can suffer lengthy bear markets in their own right.

Bond allocation guidelines

Whatever your asset-allocation goal, you should always be splitting up the bond portion between the different classes of bonds.

* Start with at least 25% invested in bonds with as little default risk as possible - this means Treasuries, inflation-indexed Treasuries or municipal bonds.

* Add an allocation of up to 65% for bond funds with "economic exposure," such as those focused on highly rated corporate bonds. These usually outperform Treasuries when the economy heats up. A fund is a better choice than direct investment for most investors because it offers a level of diversification few investors achieve with individual corporate bonds.

* Don't neglect junk bonds. They deserve at least 10% of your bond investment. High yield bonds correlate more closely with equities than with fixed income investments, and their higher yields can compensate when Treasury yields are low. Don't buy direct - funds are the only safe way to play the high-yield market.