The brilliance of boring, high-quality bonds

Last week, the U.S. stock market dropped 2.6 percent, with narrow stock indexes like the Dow Jones industrials ending down for the year. Many say stocks have huge risks, and Wall Street could be staring at the beginning of the next great bear market. Suddenly bonds, shunned by many investment advisors, don't look quite as stupid as they did going into the year.

To see why boring high-quality bonds and bond funds are so essential to a portfolio, let's go back to March 9, 2009. The stock market had plunged, and "cash is king" echoed throughout the investing world. Advisors dramatically increased clients' allocations to cash and bonds, but stocks then began a long surge of 240.5 percent, as measured by the total return of the Vanguard Total Stock Market Index ETF (VTI), to July 24 of this year.

Unfortunately, few had the cash or courage to buy stocks when this great equity sale was open to anyone because, according to Morningstar, the average bond fund lost about eight percent in 2008. Many so-called safe bond funds like the Oppenheimer Core Bond Fund (OPBCX) lost over 36 percent. The Schwab Yield Plus bond fund, marketed as a safe alternative to a money market, did even worse, resulting in a lawsuit settlement.

That's where the brilliance of a boring high-quality bond fund comes in. Those that follow what's now called the Barclays Aggregate Bond Fund index, such as the iShares Core U.S. Aggregate Bond Fund ETF (AGG) or Vanguard Total Bond Fund ETF (BND), gained more than 6 percent during the 2008 stock market crash. Holders of these bond funds were more likely to have the courage to convert some holdings to cash and profit from the great stock sale.

Fast-forward to today. No one knows whether last week was just another tiny blip in the great bull market or a harbinger of the next market plunge. But investors who keep a balanced portfolio are perfectly positioned to profit from a moderate to major decline. That is, if they're keeping their bond portfolio in high-quality issues rather than trying to eke out another 0.50 percent annual return.

Here are three things to keep in mind when buying high-quality bond funds.

First, stocks are riskier in a day than bonds are in a year. The bond funds mentioned above lost about two percent last year, which is about what stocks lost on July 31 alone.

Second, economists have no clue whether interest rates will rise. The consensus for 2014 was a definite increase. Their long-run track record of being wrong continues with rates declining and these bond funds gaining over 3.6 percent.

Third, interest rate risk is only short-term and ultimately results in higher yields for bond funds. Credit (or default) risk is something investors never recover from.

So, my advice is to keep a constant allocation to high-quality bond funds or certificates of deposits backed by the U.S. government via the Federal Deposit Insurance Corp. or the National Credit Union Administration. Take your risks with stocks. Your boring bonds will eventually be a brilliant strategy.