Feb. 11, 2003 — Faced with a three-year-old bear market, people have been abandoning stocks and embracing bonds in droves.

But investors shouldn’t lose sight of a principle that applies to buying both: the need to diversify. Owning debt instruments of different issuers and maturities can help minimize risks given the current juncture.

“You tend to limit your losses on the downside when you’re in many sectors of the (bond) market,” says Edmund Notzon, III, a bond fund manager with T.Rowe Price Group (TROW).

Notzon recommends that, in general, investors hold 80%-90% of their fixed-income assets in investment-grade bonds. These include corporate bonds as well as securities offered by the Treasury and government agencies.

Professionals say high-yield, or junk bonds, should be included in fixed-income portfolios because they can boost yields. However, they caution against allocating more than more a relatively small portion of your assets here.

“Ten percent to 20%, I think, is plenty,” says Notzon. “Because more than that and you’re definitely going to be increasing the volatility of your portfolio, and you might be inclined to bail out of it if it has a period of substantial underperformance.”

Junk bonds have not done as well as investment-grade securities over the last few years. Because of that, though, they have become cheap and now “represent a good value,” Notzon says. High-yield bond funds as tracked by Standard & Poor’s lost 0.9% in 2002, but gained 6% in the fourth quarter, and another 2% in January.

Given the current low interest rate environment, Vanguard bond fund manager Robert Auwaerter, along with other professionals, says he thinks investors should be looking at short or intermediate-term bonds, which are less sensitive to changes in interest rates than those with longer maturities.

Yields for long-term bond funds currently may be attractive, but to get them investors would be “taking on a ton of risk” of losing their principal if interest rates increase even marginally, he notes. As it is in stock picking, risk tolerance and a person’s time horizon for investing are considerations in buying bonds.

Another key factor in compiling a fixed-income portfolio is a person’s reason for investing, says Gary Arne a managing director with Standard & Poor’s Fund Services who focuses on bond funds.

If your goal is short-term, like buying a house, then safety and principal protection are important. In that case, Arne says, you would look at high-quality, short-term bonds, like those issued by the Treasury.

For investors seeking diversity in one bond mutual fund, index funds that track fixed-income gauges may be the right choice.

Vanguard, for example, offers four bond index funds, including Vanguard Total Bond Market Index (VBMFX), which seeks to match the performance of the Lehman Brothers Aggregate Bond Index, a stand in for the entire domestic taxable bond market. The T Rowe Price US Bond Index (PBDIX) also tracks the Lehman Brothers index.

Similarly, the T Rowe Price Spectrum Fds Income Fund (RPSIX) that Notzon manages offers diversity by investing in a group of T. Rowe Price domestic and foreign bond funds, a money market fund and an income-oriented stock fund.