The Diversification Decision: Bonds or Short-Term Accounts?

What have bonds done for you lately?

Probably nothing spectacular, unless you’ve had uncanny timing.

And that’s why many investors who are facing the classic portfolio decision--how to diversify part of their assets away from the stock market--may be thinking that using a money market fund or other short-term account for diversification makes more sense than bothering with bonds.

Consider these performance data:

* Long-term government bond mutual funds have produced an average total return--that’s interest earnings plus or minus any change in principal value--of 5.7% a year over the last five years, according to fund tracker Morningstar Inc.

* In the same period, ultra-short-term bond funds, which own securities maturing in no more than one year, have generated an average total return of 5.3% a year.

In other words, investors who kept their money in long-term bonds, with all of the various risks associated with that strategy, earned just 0.4 percentage point more a year than investors who opted for the simpler solution of staying short term.

Given the current situation with interest rates, the question of whether to keep fixed-income assets in long-term or short-term securities looms as large as ever.

The average money market mutual fund’s seven-day compound yield now is just above 6%. Normally, shorter-term fixed-income securities pay less than longer-term securities. But because of several factors, you actually get a lower yield today on 10-year Treasury notes--5.99% as of Monday--than on money market funds.

Since the mid-1990s, the “spread” between short- and long-term Treasury yields has tended to be fairly tight. That’s in sharp contrast to the early ‘90s, when long-term yields were far above short-term yields.

David M. Jones, chief economist at bond dealer Aubrey G. Lanston & Co. in New York, favors staying with shorter-term securities now, at least in terms of the Treasury market.

The federal government’s current program of buying back 10- to 30-year Treasuries (thanks to the budget surplus) is helping to keep longer-term Treasury yields depressed, he noted. That could continue for some time.

West Los Angeles financial planner Joel Framson also favors shorter-term fixed-income investments for investors looking to diversify away from stocks. He pointed to a recent study by Dimensional Fund Advisors that shows shorter-term bonds have closely tracked longer-term bond returns not just over the last five years but the last 20 to 25 years.

One big advantage in keeping fixed-income assets in a money market fund or other short-term account is liquidity: That money is always available to you, and your principal is virtually secure.

For investors who want a capital-preservation element in their portfolio to offset stocks’ volatility, money funds are hard to beat right now.

By contrast, longer-term bonds’ principal value can decline if market interest rates rise. Why? Here’s a simple example: If a newly issued 10-year bond pays 6%, a 10-year bond issued a year ago at a fixed yield of 5% naturally isn’t going to attract buyers--unless its price is “marked down” accordingly.

As the Federal Reserve has pushed interest rates in general higher over the last year to slow the economy, older bonds have been devalued.

Hence, the total return on the average long-term government bond mutual fund was just 4.5% in the 12 months ended June 30, even though the interest paid by the funds produced a yield of 5.6% in that period. The lower total return reflects the funds’ loss of principal value.

But market interest rates’ effect on longer-term bonds also can be beneficial: If market yields were to tumble in the years ahead, existing bonds at higher yields would soar in value--producing a bigger total return.

Money market funds, meanwhile, would simply pay less if market rates were to fall, with no added benefit of a principal gain.

Some analysts say the rise in longer-term yields over the last year makes some segments of the bond market attractive now for investors looking for long-term diversification.

If you trust that the Fed is succeeding in its mission to slow the economy without pushing the nation into recession, there could be good value in longer-term bonds, particularly among high-quality corporate issues, said Sung Won Sohn, chief economist of Wells Fargo Securities in Minneapolis.

The average long-term investment-grade corporate bond fund’s annualized yield is more than 6.6% now, according to Morningstar. Year to date, the principal value of those funds has slipped slightly, producing an average total return of just 2.5% in the first half.

Still, even in a period of rising interest rates, high-quality bonds’ principal losses are likely to be modest compared with the losses stocks can suffer.

Sohn also likes municipal bonds. The average long-term municipal bond fund yields about 5% now. In the case of funds that own only California muni issues, that yield is exempt from state income tax as well as federal income tax--so the true return is much higher, depending on your tax bracket.

The one bond sector that still makes Sohn and others nervous is “junk” corporate bonds--those issued by companies considered less than investment grade.

The average junk-bond mutual fund’s annualized yield is more than 10% now. Yet in the first half of this year, the decline in the bonds’ principal values more than wiped out the interest earnings, producing a total return of minus 0.5%.

If the economy continues to slow, financially weaker companies are likely to have trouble paying their bills, leading to rising defaults in the junk-bond market, analysts warn.

But a slowdown--if it accomplishes the Fed’s goal of keeping inflation subdued--could be the best possible news for fixed-income investors in the long run. That’s because inflation is bonds’ No. 1 enemy, eroding fixed yields over time.

“If policymakers are worried about inflation, investors don’t have to be,” said Harold Woolley, fixed-income strategist for Bessemer Trust in New York, which manages money for institutions and wealthy individuals.

As long as the Fed maintains its vigilance, bonds should provide decent “real,” or inflation-adjusted, returns, he said. They may not provide what stocks provide, but that’s not the point: You generally own bonds to lower the overall risk of capital loss in your portfolio.

There’s also a way to beat inflation without counting on the Fed to keep it in check: Buy inflation-indexed Treasury bonds.

The return on inflation-indexed bonds is adjusted over time to make up for any increases in the consumer price index. The bonds, known as TIPS, can be purchased individually. Also, some mutual fund companies, including Vanguard Group, have launched TIPS bond funds.

Note, though, that the quirky tax features of TIPS bonds makes them suitable primarily for tax-sheltered accounts, such as individual retirement accounts.

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Thomas S. Mulligan can be reached at thomas.mulligan@latimes.com.