10 Ways Bonds Can Hurt Your Portfolio

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By Tim Lemke

Bonds and bond funds can be an integral part of most portfolios. Not only can they can bring some stability to help guard against big losses, but in some cases they can also generate a healthy return.

But bonds can also be a drag on your portfolio if you're not thoughtful about what you're buying. The key is to understand what you want to accomplish with bonds, and invest only in those that make sense for you and your investment goals. Paying attention to taxes and fees is also crucial.

Here are 10 ways that bond investing may be sapping the energy from your portfolio.

1. You Are Investing in Too Many

If you're young, you don't need a heavy dose of bonds, as their generally lower returns can be a drag on growth. Bonds help stabilize a portfolio, but young people have a long time horizon to make up losses, and can afford to be more stock-heavy in their investments. Consider scaling back your bond exposure to 15 percent or less, or even none at all.

2. Your Bonds Aren't Good Bonds

Sometimes you choose a bond or bond fund because it's what's offered in your 401(k) plan or because someone recommended it. But is it actually a quality investment? Did you do your research to see if you can get into something better? Look to resources like Morningstar (MORN) for ratings on bond investments, historical performance, management and fees.

3. Fees

Some bond funds may take 1 percent or more in management and other fees. There's not a lot of evidence that high fees will result in better investment performance. Look for funds that have low expense ratios of a half-percent or less, such as the Vanguard Total Market Bond Index Fund.

4. Taxes

If your bonds are in a taxable brokerage account, it may be best to get tax-free municipal bonds to save on that tax bill. Interest on most corporate bonds is taxed at the ordinary income rate, but you may be able to avoid taxes if you choose municipal bonds. Consider placing any taxable bond investments in a tax-advantaged retirement account, such as Roth IRA or 401(k).

5. Your Bond Selection Is Too Conservative

If you are close to retirement, you may be best investing in a stable bond fund without much volatility. But if you are younger, you're going to want some growth, too. You might be best off with a high-yield bond fund, which carries more risk but the potential for greater returns. Don't let fear prevent you from taking a little risk. If you're years away from retirement, you can afford to be a little more aggressive.

6. Your Bond Selection Is Too Risky

If you are on the cusp of retirement, you may want to focus on stable value bond funds and other bond investments that don't come with a lot of volatility. Avoid bond funds comprised of low quality bonds. Don't buy municipal bonds from cities on the verge of bankruptcy. Look for bonds with a track record of avoiding losses even during the rough times.

7. You Have Too Many Bond Funds and Not Enough Actual Bonds (or Vice Versa)

Many people don't see a material difference between investing in bonds versus bond mutual funds. It's tempting to invest in bond mutual funds because of the diversity of bond exposure, but with individual bonds, you'll get all of your principal back as long as you hang onto it through maturity. Bond funds, on the other hand, have no maturity date and could drop in value. There are pros and cons to holding each, so it makes sense to have a mix, if you can.

8. You Have Too Many Long-Term Bonds

If you invest in shorter term bonds, you won't be impacted as much as interest rates rise. The last thing you want is to be locked into a low rate for years and years. With talk of interest rates rising, it's important to remember that interest rates and bond prices move in opposite directions. Longer term bonds will see price drops that are bigger than short-term bonds.

9. You Have Too Many Short-Term Bonds

Short-term bonds are a good way to hedge against interest rate hikes. But long-term bonds tend to have higher returns. If you're not seeing the kind of performance you want from your portfolio, it could be that you are too focused on short-term bonds.

10. You're Not Diversified Enough

If you're not thoughtful about your bond investing, you may find yourself holding many of the same kinds of bonds unnecessarily. There's no need to own shares of several bond funds with similar holdings and philosophies, for instance. And be careful not to invest in a mutual fund that holds bonds that you also own individually.

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