Vanguard Research Paper States the Case for Bond Diversification

It also provides a basis for assessing the future economic scenario that is "priced into" today's bond valuations (and hence into the forward yield curve), leading to a discussion of why expectations for future interest-rate movements seem generally plausible.

Davis concludes, most broadly, that scenarios producing the highest relative returns in the short run (such as a double-dip recession scenario) would be expected to produce the lowest relative returns over the long run. Conversely, scenarios in which rates rise more than is currently expected (such as from a fiscal crisis or a run-up in inflation) could actually produce the highest relative nominal returns over a 10-year period.

"The results of our scenarios, together with the performance of various bond segments over the past several years, underscore the benefits of a broadly diversified fixed income portfolio regardless of the future direction of interest rates," Davis writes. "A key lesson of the global financial crisis is that implementing a too narrow or 'surgical' bond allocation (such as by shortening duration or investing solely in riskier bond instruments) involves important trade-offs that may expose investors to unintended yield-curve or credit risks, while potentially depriving them of a higher or less volatile future income stream. The high uncertainty surrounding the future direction of economic growth, the deficit, inflation, and interest rates would seem to support greater fixed income diversification, not less."

Michael S. Fischer ([email protected]) is a New York-based financial writer and editor and a frequent contributor to Wealth Manager.