In the ice-cream parlor of investment choices, bonds often get the rep of being plain vanilla. After all, bonds don't typically offer up the chance for double-digit gains in short time spans like equities do. Most investors prefer the more complex and tastier flavors of stocks, leaving bonds to play a backup role in their portfolios.
But bonds are an important part of a balanced portfolio: They dampen volatility and protect capital. While they may not get a lot of respect from stock-crazy investors, they are an indispensable part of almost any investment plan. So it just makes sense to keep an ear to the ground and pay attention to what is going on in the bond market.
Advice from the top
In the fixed-income world, few people are more highly regarded than Bill Gross, chief investment officer of the Pacific Investment Management Company, or PIMCO. His uncanny ability to predict macroeconomic trends has earned Gross's clients untold millions over the years.
Gross's renowned PIMCO Total Return Fund (PTTAX) is the world's largest bond fund, and its long-term returns place it among the top tier of such funds. When Bill Gross speaks, people listen. And recently, Gross made an emphatic statement regarding one of the most popular segments of the bond market.
Gross said on CNBC, "I think Treasuries are the most overvalued asset in the world, bar none." He went on to say that he and his team were moving out further on the credit spectrum and buying AA- and A-rated bonds, although it was too soon to move into the high-yield arena. He argued that it was difficult to justify investing in Treasuries, given expected levels of inflation.
Fleeing the scene
So should bond investors start dumping their Treasury holdings? Not so fast. Do I think that government bonds are overvalued? Yes, they likely are. Over the past year, the yield on the 10-year Treasury bond has fallen from 4.8% to around 3.9%. Because bond yields and prices are inversely related, this means that the price of a 10-year bond has risen steadily since mid-2007. In recent months, fears of a recession have spurred bond prices even higher, as investors have sought the relative safety of Treasury securities.
But for many fixed-income investors, keeping some money in Treasuries may still make the most sense for their portfolio. Most investors should have at least some diversified exposure to the domestic bond market, including government securities, mortgage securities, and corporate bonds.
Of course, it still makes sense for conservative investors to also keep a toe in the equity market and maintain exposure to large-cap blue chip stocks like General Electric (NYSE: GE ) and Microsoft (Nasdaq: MSFT ) , as well as mid-cap and small-cap gems like Lincoln Electric Holdings (Nasdaq: LECO ) and Simpson Manufacturing (NYSE: SSD ) . But for investors with a lower risk tolerance or shorter time horizon, bonds should take first priority in a portfolio, and that includes having a decent allocation to U.S. Treasuries.
It's true that Treasuries may be in for a rough ride this year and next, and investors should remember that bonds can and do lose money -- even ultra-safe Treasuries. In fact, the Lehman Brothers Government Bond Index has posted negative returns in 14 calendar quarters over the past 10 years. But this doesn't negate their long-term usefulness in a portfolio.
And as Bill Gross himself said, exactly five years ago, "I still prefer an overvalued Treasury to an overvalued stock."
Bonding with the experts
One of the easier ways for investors to get exposure to the bond market is through a well-diversified exchange-traded fund. As luck would have it, bond ETFs have been hitting the market by the dozens in recent months. Some of the best low-cost, diversified ETFs include the iShares Lehman Government/Credit Bond ETF (NYSE: GBF ) , the Vanguard Total Bond Market ETF, and the SPDR Lehman Aggregate Bond ETF (LAG).
Investors who want a shorter-term focus might want to consider the Vanguard Short-Term Bond ETF (AMEX: BSV ) . And for folks who want high yield exposure, the SPDR Lehman High Yield Bond ETF (AMEX: JNK ) fits the bill.
But if you really want to try to outsmart the bond market, instead of just tracking it, actively managed bond funds are the way to go. Investing in bond funds means that you can take advantage of the expertise of some of the best minds in the business, like ... Bill Gross.
A better way
Everyone knows about his PIMCO Total Return Fund, but the fund-picking team at the Motley Fool Champion Funds investment service has the inside scoop on another bond fund that Gross manages that has performed even better than the Total Return Fund. And best of all, this fund doesn't come with an onerous front-end load like the Total Return Fund does.
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This article was originally published April 19, 2008. It has been updated.
Amanda Kish heads up the Fool's Champion Funds newsletter service. At the time of publication, she did not own any of the funds mentioned herein. Microsoft is an Inside Value selection. Simpson Manufacturing is a Hidden Gems recommendation. The Fool's disclosure policy is a rich, creamy chocolate.