If you mix a cocker spaniel with a poodle, you'll get a cockapoo. A Jack Russell terrier and a pug will produce a jug. Stir in a beagle, a bloodhound and a collie, and you'll get a mutt.
No disrespect to any breed, but mutts can often be healthier and smarter than purebreds. Similarly, mixing different types of income-producing investments can often produce a superior breed of income portfolio. Think of them as mixed-breed bond funds.
If you own a fund that mirrors the Standard & Poor's 500-stock index, for example, it may help your overall returns if you add a bond fund to your holdings. Bond funds aren't closely correlated with the S&P 500. So when the broad stock market falls, your bond fund's price may rise, easing your pain a bit.
The same principle applies to bonds and other income-producing funds. Mixing different types of income-producing funds can help squeeze out higher returns from your portfolio, adjusted for the amount of risk you take. The trick is to find funds with a low correlation to the overall bond market.
It makes no sense to have, say, a pack of municipal bond funds or a pack of Treasury bond funds. You'll just have more funds to track and, quite possibly, higher expenses, too.
Similarly, you won't get much diversification by adding, say, a high-quality bond fund to a Treasury bond fund. The high-quality corporate bond market and the Treasury market are too closely correlated.
A statistical measure called r-squared helps illustrate how closely tied some types of bond funds are to each other. R-squared shows how much of a fund's price movements can be explained by a benchmark index. For example, about 92 percent of the price movements in Lipper's high-quality bond fund index reflect movements in the Lehman U.S. Treasury total return index.
But several types of income-producing funds tend to zig when Treasury bonds zag. Here are a few of those fund categories that could be paired with Treasuries in a diversified bond portfolio:
High-yield bond funds. Also called junk-bond funds, these invest in low-quality, high-yielding corporate IOUs. Junk funds are more closely correlated to the stock market than to the bond market. Fidelity Capital & Income (ticker: FAGIX) has been the top-performing high-yield bond fund over the past 10 years.
International income funds. These funds buy high-quality bonds issued overseas. Because many of these bonds are denominated in foreign currencies, they offer more diversification than a U.S. corporate bond fund does -- but more risk, too. Oppenheimer International Bond (OIBAX) has one of the best records in the category.
Emerging market debt funds. They offer even more diversification but are also more of a gamble. Many emerging market bonds are denominated in U.S. dollars. Yet the countries themselves are more prone to political and economic turmoil. T. Rowe Price Emerging Market Bond (PREMX) is one of the top-performing funds in this category.
Real estate funds. These funds invest mainly in real estate investment trusts, or REITs. With REITs, dividend payouts are typically high -- currently averaging 3.78 percent. But their huge price runups recently have translated into lower yields -- and the risk of a correction. Fidelity Real Estate Income (FRIFX) sports one of the highest yields among real estate funds.
Money market funds. Right now, though, the lowly money market fund is probably your best diversifier. Not only do money funds have a low correlation to bonds and stocks; they also yield as much as -- or more than -- many Treasury notes, bonds or bills. The average money fund yields 4.73 percent, according to iMoneyNet.com, which tracks the funds. Many of the top-yielding money funds yield more than 5 percent.
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