The Types of Bonds That Your Portfolio May Need—and the Bond Types It Can Do Without

Key Takeaways

• Bonds bring two main things to our portfolios. They bring some level of income, often a higher level of income than equities infer, and they also bring a diversification benefit, which can help lower our portfolio’s volatility.
• When trying to diversify your portfolio, assuming you have a base of US equities, you’d bring into the portfolio assets that are negatively correlated with stocks, so when your stocks are down, this asset is going to go up.
• High-quality bonds, especially Treasury bonds, look good from the standpoint of diversifying equities, and cash has recently looked really good as well. That both suggests that if you’re going to add one or two additional assets to that US equity portfolio, your next stopping point should be cash and high-quality fixed-income assets.
• High-yield bonds have been consistently weak diversifiers with performance that is very closely correlated to the stock market. Another grouping of bonds that look a little less good than Treasuries from the standpoint of diversifying equities would be core, intermediate-term core, and intermediate-term core-plus bond types.
• Investors could make a case for holding a little bit of junk-bond exposure as kind of a fixed-income kicker or maybe even taking some of what you might otherwise allocate to equity assets and put it into junk bonds as sort of a lower-risk way to obtain equitylike exposure.
• We found municipal bonds aren’t quite as attractive in terms of diversifying an equity portfolio as Treasury bonds or as cash, but they still are decent diversifiers.

Margaret Giles: Hi. I’m Margaret Giles with Morningstar. Who needs bonds? What bond types are the best to own, and which are best left out of your portfolio altogether? Joining me to discuss those questions is Christine Benz. Christine is Morningstar’s director of personal finance and retirement planning and host of The Long View podcast.

Christine, thanks for being here.

Christine Benz: Margaret, it’s great to see you.

Who Needs to Invest in Bonds?

Giles: So let’s start with a basic question. Who needs bonds and why?

Benz: I’ll start with why. So bonds bring two main things to our portfolios. They bring some level of income, often a higher level of income than equities infer, and they also bring a diversification benefit, which can help lower our portfolio’s volatility.

So those are the two main qualities that they bring to a portfolio. And for people who are in the accumulation phase, they are mainly looking to that diversification benefit that with even a little bit of fixed-income exposure in a portfolio that’s mainly equities, you can bring down the volatility in that portfolio quite significantly. So for people in the accumulation phase, the diversification benefit is the main benefit.

For people who are in retirement, that diversification benefit is still really valuable, but they’re also securing-the fixed-income securities-are securing a portion of the retiree’s cash flows. They’re helping to stabilize it, effectively lock it down, so the retiree doesn’t have to worry so much about what’s going on in the equity market. They know that they have a stable source of funds that they could pull from in a pinch. So those are the two main constituents and the two main advantages that bonds bring to bear on a portfolio.

How Do Bonds Work in Your Portfolio?

Giles: So you contribute to some annual research on diversification and correlations among asset classes. So how do you go about judging bonds’ usefulness in a portfolio?

Benz: So in the research we assume that the base asset that someone is bringing to a portfolio is US equities. So then we take all the other asset classes, we use our database to regress their returns against US equities, and what we’re looking for is a low correlation in performance. So ideally, you’d bring into the portfolio assets that are negatively correlated with stocks, so when your stocks are down, this asset is going to go up. It’s hard to find those assets that go down—or that go up—when stocks go down, but in any case, you’re looking for something that has not a super close correlation with equities, and that’s the basic exercise that we run through when we look at various asset classes in this research.

Why High-Quality Bonds Are Best to Protect Against Stock Market Movements

Giles: So when you ran these regressions, which bond types tended to look the best as that ballast for equities?

Benz: It’s been a pretty consistent finding, Margaret, that high-quality bonds, especially Treasury bonds, look good from the standpoint of diversifying equities, and cash has recently looked really good as well. That both suggests that if you’re going to add one or two additional assets to that US equity portfolio, your next stopping point should be cash and high-quality fixed-income assets.

Which Bonds Have Been Weak Portfolio Diversifiers?

Giles: All right. So now on the other side of things, which bond types were disappointing from the standpoint of adding diversification to a portfolio?

Benz: High-yield bonds have been consistently weak diversifiers with performance that is very closely correlated to the stock market. The reason is pretty intuitive. When investors are worried about stocks, they’re often worried about the health of the economy and that can weigh on the prospects of these highly leveraged companies that need to borrow from investors at fairly high interest rates. So we typically see junk bonds move in sympathy with the equity market.

Another grouping of bonds that look a little less good than Treasuries from the standpoint of diversifying equities would be what we call core, intermediate-term core, and intermediate-term core-plus bond types. These typically have bigger positions in corporate bonds relative to Treasuries and those tend to make them less effective as equity diversifiers than Treasuries and certainly cash.

Why Investors May Not Want to Completely Avoid Junk Bonds

Giles: Does that mean that investors should just be skipping them altogether?

Benz: Well, probably not necessarily. So investors could make a case for holding a little bit of junk-bond exposure as kind of a fixed-income kicker or maybe even taking some of what you might otherwise allocate to equity assets and put it into junk bonds as sort of a lower-risk way to obtain equitylike exposure. With core and core-plus type bonds, it’s important to note that their returns have historically been better than Treasuries and so correlations, while they can be important in terms of how you construct a portfolio, they’re not the be-all end-all. So intermediate-term core and core-plus bond types have tended to have better return potential even though their diversification benefit isn’t as great.

Will Cash Continue to Be Better for Portfolio Diversification Than Bonds?

Giles: Speaking of that diversification benefit, cash has recently looked even better than bonds as a diversifier. Can you explain why that’s happened, and do you expect this trend to continue?

Benz: Good question. I think it’s largely an artifact of the fact that yields on both cash and bonds were so low for quite a long time, and there was a very narrow separation in terms of what they brought to bear on a portfolio. When we saw interest rates jump up in sort of the late 2021/2022 period, cash came out the winner because the cash investor is able to benefit from higher yields. The bond investor is a loser in that scenario. Whether that will be a persistent pattern, I think is an open question, which is why I would own both as a component of the portfolio. I think both bring a lot to a portfolio that is dominated by equities.

Are Municipal Bonds Good Equity Diversifiers?

Giles: So lastly, you also examined municipal bond’s value as equity diversifiers. What did you find?

Benz: We found that they aren’t quite as attractive in terms of diversifying an equity portfolio as Treasury bonds or as cash, but they still are decent diversifiers. If we dial out a little bit, we see that municipal bonds over long periods of time do do a pretty good job of being equity ballast. For investors who are in high tax brackets, I think they still are a decent place to park the short-term money that you might want to hold in your taxable accounts. We did see a little bit of a bobble in muni prices recently in this tariff-related equity market downdraft, but over longer stretches of time, municipal bonds have looked pretty decent from the standpoint of diversifying equity exposure.

Giles: All right. So this insight has been helpful in these different bond types and how they fit in. Christine, thanks for taking the time.

Benz: Thanks so much, Margaret.

Giles: I’m Margaret Giles with Morningstar. Thanks for watching.

Watch 5 Key Investing Lessons From Recent Market Volatility for more from Christine Benz.