Selecting the appropriate bond fund for your portfolio provides both income and risk management.

• It is advisable to have some of your investment in bonds if you have a diversified portfolio.
• Bonds not only provide some protection against market fluctuations but also generate income.
• Morningstar gives some of its top bond funds.

To protect your investments from market volatility and generate income, it is advisable to have a diversified portfolio that includes bonds.

Constructing the fixed income portion of your portfolio can be perplexing, particularly following the bond market downturn in 2022 and the ongoing volatility in 2023. In October, the yield surpassed 5%. Bond yields are inversely related to prices, so when yields increase, prices decrease.

The Federal Reserve's decision to cut interest rates is being closely monitored by investors this year.

The Fed's decision to cut rates may cause stock and bond returns to move in opposite directions, resulting in a mix of the two as an attractive risk-return profile, according to Morgan Stanley's 2024 bond market outlook.

Mike Mulach, a senior analyst at Morningstar, advised investors not to attempt to time the market.

"Diversify as much as possible," he advised. "There will be fluctuations, and there has been more volatility recently. However, there will come a time when you won't be able to remain in cash."

Bonds vs. bond funds

Sovereign Financial Group founder Chuck Failla, a certified financial planner, advised owning individual bonds only if they are of high quality.

For instance, Treasurys can be bought through the TreasuryDirect website.

As Failla stated, when you enter into individual bonds, there is a predetermined duration, and you will receive income along the way until the bond matures, at which point you will receive your principal back.

To achieve your specific time goal, you should stagger the maturities of the bonds, he advised.

Most investors should consider purchasing a diversified bond fund, advised Mulach.

He stated that it's not necessary to use a sector fund, but rather to focus on high-quality bonds and bond funds that offer the best diversification against riskier assets, such as equities, in your portfolio.

What to look for in bond funds

There are several factors to consider when investing in a bond fund.

"Starting with the cheapest options is a wise choice," Mulach advised.

Investors should be aware of interest rate risk, which is the impact of interest rate changes on the asset's underlying price. The best way to assess this is through the bond fund's duration, Mulach said.

Investors face less credit risk when bonds have higher quality.

He explained that high-quality bond portfolios provide the greatest diversification benefits relative to equities in your portfolio.

Last year, Morningstar reported that actively managed bond funds outperformed their passive counterparts.

Because of that outperformance, Mulach generally recommends actively managed funds.

High-quality managers are crucial when searching for funds, as both Mulach and Failla emphasized.

Failla advised considering the track record, but not solely relying on it. Additionally, examine the default rate, tenure of managers with the funds, and their asset selection process, he suggested.

"To mitigate the risks in that space, it's important to have a real process in place," he said. "There are many good managers out there, but it takes effort to find them."

Mulach recommends sticking with Morningstar's intermediate-core, short-term, and ultra-short term bond categories. Ultra-short funds typically have durations less than one year, while short-term funds last between one and 3.5 years. Intermediate-core funds typically fall within the range of 75% to 135% of the three-year average of the effective duration of the Morningstar Core Bond Index.

Ensure that the strategies within the categories are diversified, with investments in investment-grade government-backed securities, corporate-debt securities, and securitized-debt securities, he advised.

Here are some of Morningstar's top actively managed bond funds.

According to Morningstar's active/passive barometer, some managers have success rates below 50%.

Perhaps it would be more advantageous to adopt a passive approach when targeting a category, according to Mulach.

The can be a great option to simply replicate that index, he said. It can also be a way to avoid any extra risk, since active managers typically take on more risk to beat their benchmark, he said.

Failla also isn't opposed to passive exchange-traded funds for Treasurys.

"High-quality Treasurys is a very efficient market," he said. "You don't need a high-powered analyst team."

If you have a higher risk tolerance, you can potentially earn higher yields with lower-quality bonds, but be cautious as these bonds have a higher risk of default.

Failla believes actively-managed high-yield funds are a wise investment choice for his clients.

""If I have 500 bonds in my portfolio, I don't really care about the 1%, 2%, or 3% default rate, but bond funds can help me manage the risk," he said."

He assesses each person's time horizon to determine their asset allocation and reserves high-yield bonds for their future needs, which may be in approximately 10 years or more.

To minimize the tax impact of bond income, it is recommended to keep bond funds in a tax-advantaged account, such as an individual retirement account or 401(k).