When It Comes to Bonds, Don’t Be a Hero
Rather than taking a tactical approach, tailor your fixed-income position to what matters: your spending goals.
https://www.morningstar.com/portfolios/ ... nt-be-hero
Something’s up with investors and bonds.
Just within the past month, I have received reader questions such as:
“What’s the best type of bond fund to invest in when the yield curve is steepening?”
“Should I keep my safe money in cash if I’m concerned that the Federal Reserve is likely to start raising interest rates again?”
I’ve heard that same kind of talk from financial advisors, too. They tell me, in knowing tones, that “I’m keeping all of my clients’ portfolios short for now” or “We’re steering clear of bonds because we’re worried about inflation.”
It seems a lot of investors believe that the right way to invest in bonds is to be tactical, looking to current economic and interest rate conditions to inform how they approach their portfolios’ fixed-income positioning and changing things up based on those factors.
The trouble is, whatever investors are doing with their bond holdings doesn’t seem to be working out that well. In the 2025 “Mind the Gap” research, which examines how investors’ timing decisions impact their results relative to buy-and-hold strategies, Jeff Ptak found that some of the biggest gaps between funds’ total returns and investors’ actual, take-home returns occurred in bond funds. The gap was roughly 1 percentage point in rolling 10-year periods between 2000 and 2024. That may not sound catastrophic, but it is when you consider that core bond indexes like the Bloomberg US Aggregate Bond have gained just 2% over the past decade. In other words, investors cut their returns in half with ill-timed purchases and sales.
The year 2022 makes for a good case study. Investors had been shoveling money into bonds in most of the years leading up to that year’s bond market rout, but many fled amid rate increases and bond-fund losses in 2022. As a result, fewer investors were in bond funds to partake of the relatively strong fixed-income gains in 2023.
As Ptak pointed out in his piece, those investors may have taken cover in cash instruments, which in 2022 began to sport decent yields after bottoming out following the global financial crisis. Or they may have decided to get out of bond funds and lock in higher yields in individual bonds. But the total return/investor return gap has been a persistent finding in the “Mind the Gap” research. Given that the absolute return potential of bonds is constrained to begin with, that’s a problem.
To help address that, I’d recommend abandoning a tactical mindset with respect to your fixed-income portfolio. Rather than focusing on the Federal Reserve’s actions or the latest CPI or jobs reports and risk getting caught leaning the wrong way, spend more time asking questions about your own situation. After that, position your fixed-income portfolio with a long-term, strategic mindset. That way, you’ll only have to make changes when your situation does, which is probably not that often.
Here are the steps I’d recommend:
1) Audit Your Anticipated Spending Needs and Time Horizon(s)
The textbook rationale for holding bonds is that they have historically exhibited a different, lower-volatility performance pattern than stocks and are therefore a way to lower your overall portfolio’s volatility. That can make deciding how much to allocate to bonds seem a bit “black-boxy.”
But I’d say the real-world reason to hold bonds is more commonsensical: to serve as a bulwark of safe assets that you could spend from if your equities go down and stay down for a sustained period of time. That explains why retirement portfolios for young investors have limited bond exposure—they’re nowhere near needing their money—and why portfolios for older adults have relatively more in fixed-income investments and even cash.
Thus, a good first step in determining your fixed-income allocation’s size and composition is to ask yourself about anticipated portfolio spending: How much will you need and when will you need it? Morningstar’s Role in Portfolio framework uses 10 years as the line of demarcation to determine whether to be in bonds or equities. Because stocks have landed in the black more than 90% of the time in rolling 10-year periods, investors with spending horizons of at least 10 years could reasonably hold most or all of their portfolios in equities. But because stocks are less reliable over short time horizons and downturns are apt to be more pronounced, that’s where an allocation to safe assets fits in. In the Role in Portfolio framework, all of the fixed-income Morningstar Categories correspond with time horizons of less than 10 years. Similarly, my model in-retirement Bucket portfolios all hold 10 years’ worth of spending in a combination of cash and fixed-income assets.
To use a simple example, if you’re retired and spending roughly $40,000 a year from your portfolio, you’d want to earmark $400,000 of your portfolio for safer assets. In a similar vein, if you’re working and aiming to amass a home down payment in five years, you’d want to hold those assets in something other than stocks.
2) Choose Your Strategy: Individual Bonds or Bond Funds?
Once you’ve established how much to allocate to safer investments in total, the next step is to determine what tools you’ll use for the job: individual fixed-income securities or bond funds/ETFs?
Buying individual securities—for example, a basket of 10 bonds with one maturing in each of the next 10 years—can help address very specific spending needs and protect that portion of the portfolio against losses, assuming you invest in high-quality bonds whose issuers don’t default. This approach also allows you to lock in a specific yield, whereas bond mutual funds’ yields will ebb and flow based on prevailing market yields. Building a laddered portfolio of Treasury Inflation-Protected Securities is a popular strategy to address retiree spending needs.
Alternatively, you can use mutual funds or exchange-traded funds for the job. That approach doesn’t provide the same type of principal protection as buying and holding individual bonds to maturity, but it’s less rigid and can make sense for people with less precise spending goals.
3) Fine-Tune the Suballocations
If you’ve opted for mutual funds or ETFs rather than individual fixed-income securities, the key is to use your spending horizon to guide which types of funds to invest in. Morningstar’s Role in Portfolio framework has recommendations on this front, too—again, based on each category’s likelihood of having positive returns over a given holding period.
For holding periods of less than two years, the framework points to cash instruments like money market funds or high-yield savings accounts, or ultrashort-term bond funds if you don’t mind taking a bit of additional risk. That’s Bucket 1 in my Model Bucket Portfolios. These asset types generally have modest yields and return potential, but they’ll typically hold principal values steady. Certain cash-type instruments, like certificates of deposit and bank savings accounts, are FDIC-insured, while others, like money market mutual funds, are not. My bias is to not gun for extra yield with this portion of the portfolio but to put the focus on safety instead.
Bonds come into play for time horizons of between two and 10 years. All core fixed-income categories in the Role in Portfolio framework correspond with that time horizon. In my model portfolios, I’ve stairstepped the fixed-income holdings in Bucket 2 (the bond bucket) by expected spending horizon and risk level. Short-term bonds supply spending needs beyond the cash investments, accounting for another three to four years’ worth of spending needs. Intermediate-term bonds can supply cash flow needs for the horizon just beyond that, offering slightly higher yields and long-term return potential in exchange for higher volatility. My model portfolios also include a sleeve of inflation-protected bonds to preserve purchasing power with this portion of the portfolio.
Note that my model portfolios don’t include allocations to long-term bonds. The reason is that the portfolios all consist of mutual funds and ETFs, and long-term bond funds carry substantially higher volatility than intermediate-term bond funds. That can make them difficult to own: Morningstar’s “Mind the Gap” research indicates that long-term bond funds show some of the worst total return/investor return gaps of any category.
In a similar vein, my model portfolios also emphasize high-quality fixed-income investments for Bucket 2. Allocations to lower-quality bond types like high-yield and bank loans, while offering higher yields than high-quality investments, tend to exhibit more sensitivity to the economy and the equity market than higher-quality bonds. Such bonds can supply a bit of oomph to a high-quality bond portfolio, but they’re optional.
