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"Hey, what gives? I thought Fooldom was all about stock investing. If that's true, then why have an official Foolish portfolio that includes bonds (and worse, bond funds at that)? That seems like an unFoolish choice that will lessen potential returns over the long term." -- A Concerned Reader

Dear Concerned,

We didn't mean to confuse you. Remember, these portfolios are owned by Foolish retirees. As such, they aren't the normal portfolio within which we seek maximum growth over time. We're no longer contributing money to these accounts. Instead, we've reached that point in life where we're taking money and spending our children's inheritance so we can live the luxurious life of the carefree, non-working retiree. Our goal has changed. Now we want the ability to take money each year while having the pot from which we take it last at least as long as we do. We want a stable income, and we want it each year we need it. Therefore, bonds have a place in these portfolios.

As Fools, we maintain that money we know we will spend in the next three to five years should not be invested in the stock market. Stocks go down, and we don't want to sell into a down market when we need the cash. Therefore, we want that money in more stable investments like money market funds, T-Bills, CDs, and short-to-mid-term bonds. Those vehicles tend to be "safer" than the stock market over the short-term, and that means by using them there's less chance we will have insufficient cash when we need it. That's called Allocation, so the use of short-to-mid-term bonds fits the bill most appropriately. And, as a rule of thumb, they will on average provide a slightly better annual return than the other short-term, interest-paying vehicles we mentioned.

We could buy bonds as individual securities with differing maturity dates. But that means we would have to research individual securities, assess business risks, and keep maturity dates in mind so we don't have to buy replacement bonds all on the same day. Why? Because that day could be one on which interest rates are down significantly, and that would result in getting a lower rate of return than we might like. That possibility, in turn, means we must employ a complicated gyration of constructing what's called a bond ladder so only a portion of those bonds mature each year, thus ensuring a better spread of renewal interest rates. We want to keep these portfolios as simple as possible, and the required research just isn't that simple. Hence, the use of bond index funds also seems appropriate. By using them, we avoid the complications of developing bond ladders and ensure ourselves of getting an average return close to that of the bond index itself.

Why did we pick the two Vanguard bond funds we did? Because we happen to like Vanguard and believe it to be a mutual fund family that tends to act in the best interests of its customers. The funds are no-load, so no broker gets a commission on purchase, and the annual operating costs are among the lowest in the industry. Both of these factors increase the amount of dollars we can put in our pocket.

Why a short-term bond index fund and why a mid-term bond index fund? Because the shorter the term of the bonds, the lower the volatility of the underlying principal. According to Morningstar, Vanguard's short-term bond index fund has an average duration of only 2.4 years, and that of the total market index fund is 5.0 years. The longer a bond fund's duration, the more sensitive it is to interest rate changes. The more sensitive a fund is to interest rate changes, the greater the impact on the share's net asset value, or selling price. As an example, according to Morningstar, a "...fund with a duration of 10 years is twice as volatile as a fund with a five-year duration. Duration also gives an indication of how a fund's net asset value (NAV) will change as interest rates change. A fund with a five-year duration would be expected to lose 5% from its NAV if interest rates rose by one percentage point or gain 5% if interest rates fell by one percentage point."

For that reason, both of these funds fit our needs. And both match their respective bond indices quite well over their histories, too. The short-term index fund takes care of two years' income needs, while the mid-term bond fund picks up the next three years at a slightly higher average rate of return. All in all, both seem to be a good fit for our needs while keeping the amount of effort we must expend in research to a minimum. And because we all like to avoid work, who can ask for anything more?

So there you have it. The bonds are in our retirement portfolios to provide the cushion we need for income in the short-term, and bond index funds are used so we can enjoy our retired life by avoiding reams of time-consuming research.

For more on bonds, please see our chapter on them in Investing Basics, and our handy bond FAQ.