Bonds offer income and some volatility protection. Pick out the right bond fund for your portfolio

Having a diversified portfolio means you should have some of your money in bonds. The assets can offer not not some protection against market volatility, but also generate income.

Yet deciding how to construct the fixed income portion of your portfolio may seem confusing, especially after the bond rout in 2022 and continued volatility last year. In October, the 10-year Treasury yield crossed 5%. Bond yields move inversely to prices, so when yields rise, prices decline.

This year, investors are closely watching the Federal Reserve to see if and when it will begin to cut interest rates.

“As the Fed pivots toward cutting rates, stock and bond returns should once again move in opposite directions, re-establishing a mix of the two as an attractive risk-return profile,” Morgan Stanley said in its 2024 bond market outlook.

However, investors shouldn’t try to time the market, said Morningstar senior analyst Mike Mulach.

“Try to have as much diversification as you can,” he said. “There will be some volatility; there’s been more volatility lately. But there will be a time when you can’t just sit in cash.”

If you want to own individual bonds, only do so with high-quality ones, said certified financial planner Chuck Failla, founder of Sovereign Financial Group.

For instance, Treasurys can be bought through the TreasuryDirect website.

“When you go into individual bonds, you have a very predetermined duration,” Failla said. Along the way, you will collect income and you get your principal back when the bond matures.

If you’re going this route, ladder the bonds — which means staggering maturities — to meet your specific time goal, he said.

That said, in general, most investors would be best served buying a diversified bond fund, said Mulach.

“It doesn’t have to be super fancy in terms of using a sector fund, but just focusing on high-quality bonds and high-quality bond funds that will traditionally provide the best diversification benefit against riskier assets, like equities, in your portfolio,” he said.

There are several factors to consider when investing in a bond fund.

“Narrowing your choices to the cheapest in the universe is a great place to start,” Mulach said.

Yet price alone isn’t a barometer. Investors should be aware of interest rate risk, which is the impact of interest rate changes on the asset’s underlying price. The best way to assess this is through the bond fund’s duration, Mulach said.

Then there is credit risk. The higher the quality of a bond, the less credit risk for investors.

“Those investment-grade bonds, high-quality bond portfolios tend to offer the greatest diversification benefits relative to the equities in your portfolio,” he explained.

You’ll also have to decide if you want a fund that is actively managed, which typically comes with higher fees, or a passive fund, which is tied to a specific index. Active bond funds outperformed their passive peers last year, according to Morningstar.

Because of that outperformance, Mulach generally recommends actively managed funds.

Still, it isn’t that simple. Both Mulach and Failla said it is important to look for funds that have high-quality managers.

“Look at the track record, but don’t rely on it,” Failla said. Also look at the default rate, how long the managers are tenured with the funds and what their process is for selecting assets, he added.

“You want to make sure that they have a real process in place … to mitigate the risks that are in that space,” he said. “There are a lot of good managers out there, you just have to do your homework.”

Mulach suggests sticking with intermediate-core, short-term and ultra-short term Morningstar categories. Ultra-short funds typically have durations less than one year, while short-term funds stick with one to 3.5 year durations. Intermediate-core durations typically range between 75% and 135% of the three-year average of the effective duration of the Morningstar Core Bond Index.

“Even within those categories, just mak[e] sure they’re diversified strategies, mainly investing across … investment-grade government-backed securities, corporate-debt securities and securitized-debt securities,” he said.

Here are some of Morningstar’s top actively managed bond funds.

In some cases there are managers who have success rates lower than 50%, according to Morningstar’s active/passive barometer.

“If you’re throwing a dart at the category, maybe you’re better off picking a passive strategy,” Mulach said.

For instance, the iShares Core U.S. Aggregate Bond ETF can be a great option to simply replicate that index, he said. It can also be a way to avoid any extra risk, since active mangers typically take on more risk to beat their benchmark, he said.

Failla also isn’t opposed to passive exchange-traded funds for Treasurys.

“High-quality Treasurys is a very efficient market,” he said. “You don’t need some high-powered analyst team.”

Meanwhile, if you have a higher risk tolerance, you can snag some attractive yields with lower-quality bonds. Just be aware that high-yield bonds have a greater risk of default.

Failla thinks they are a good investment right now. He sticks with actively-managed high-yield funds for his clients.

“1%, 2%, 3% of bonds in that portfolio will default, but if I have 500 of them I don’t really care,” he said. “That is where bond funds shine.”

He looks at each individual’s time horizon to determine asset allocation and reserves high-yield bonds for what they’ll need in about 10 years or more.

Lastly, keep in mind that income from bonds are taxed as income, compared to stocks, whose gains are taxed at a lower capital gains rate. For this reason, Mulach suggests keeping your bond funds in a tax-advantaged account, like an individual retirement account or 401(k).