Bond Allocation
When designing an allocation plan you should design your stock and bond allocations separately. What this means is you will develop a bond allocation without considering what your stock allocation will look like. This will enable you too completely concentrate on the bond allocation without worrying about what percentage of bonds your overall allocation will include. Later on you can combine the stock and bond allocations to create a complete portfolio.
The ultimate goal of our bond allocation is capture the entire bond market. That being the case designing a bond allocation is rather simple. What we want is an index fund that contains as much of the bond market as possible. Most often the Lehman Brothers Aggregate Bond Index is used to accomplish the task. This index is a broad based index that includes a range of investment-grade bonds with different quality, maturities, and issuers. It includes government securities, asset backed securities, mortgage-backed securities and corporate bonds.
Many investors will simply select the Lehman Brothers Aggregate Bond index and use it for 100% of there bond allocation. Simply using this index is an easy solution to a bond allocation as it provides a well diversified solution that is cheap and easy to implement. However, this index does not include every worthwhile bond security. The most noteworthy of which are Treasury Inflation Protected Securities (TIPS).
TIPS, which where first introduced in the late 1990, are designed to protect against inflation. Just like every other bond TIPS pay semiannual interest and have maturity dates. Where they start to differ from normal bonds is the fact that their interest payments are not fixed. In times of inflation the value of these bonds and the interest they pay will rise at the rate of inflation. During times of deflation just the opposite happens. As such TIPS have a low correlation with normal bonds and stocks. This makes them a valuable addition to any bond allocation.
The above chart is a risk and reward chart that was created using 100% Total Bond Market, and 100% Treasury Inflation Protected Securities. The left point on the line consists of a bond allocation that is 100% TBM while the right hand side of the line is 100% TIPS. This chart demonstrates how adding some TIPS to a bond allocation will lower your standard deviation while not sacrificing returns. From a pure risk and reward relationship, only using these two indexes, the optimal bond portfolio would be about 65% TBM and 35% TIPS. Such a portfolio would reduce your bond allocations standard deviation by a third while not sacrificing return.
I must mention the inclusion of High-Yield corporate bonds to a bond allocation. High-Yield corporate bonds are the securities that are often referred to as speculative-grade bonds, non investment grade bonds, and junk bonds. A real danger exists that that the issuers of these bonds will default. As such they tend to pay higher returns but are extremely risky.
In our asset allocation bonds are used to be the safe haven portion of the portfolio. That is to say we use stocks to generate returns while we use bonds to lower our risk. Adding high-yield corporate bonds goes against this tenant and as such we will not include them. However, if you are inclined to use them, know that they have a low correlation with the rest of the bond market. This can provide an additional diversification benefit but it should be considered part of your equity allocation and not your bond allocation.