There is much buzz about the flight of major fund advisors like Bill Gross from Treasuries, the low-reward nature of TIPS and the generally dismal outlook of money market funds at the moment. Of course, this leads people to look for yield in other places – corporate bonds, perhaps high-yielding junk bonds or even abroad in high-risk emerging markets. Is this dangerous behavior? Maybe, but maybe not.
Correlations: while taking on credit risk (or country risk) can be dangerous in itself, the biggest danger is in failing to notice the other forms of related risk in non-US-government bond funds. Specifically: they tend to rise and fall with equities. That said, they do not move in lockstep with stocks and can provide additional diversification benefit, so long as one does not fool oneself into believing they are fundamentally ‘safe’ – it might be best, for instance, to treat higher-risk bond holdings as part bond and part equity in one’s asset allocation.
Diversification: some would argue that one can get international diversification through ex-US equity holdings. While this is true, there may be further diversification benefits to holding foreign-currency bonds as well – it partly depends upon the goals and situation of the particular investor.
Rebalancing: in part due to changes in exchange rates, there is a rebalancing benefit to be had here as well – since higher-risk bonds move differently from flight-to-safety Treasuries or roller-coaster equities they can, particularly if one has a great deal of tax-advantaged space to store them in, gain from re-leveling one’s allocation with bands or on a schedule.
Conclusion: a broadly-diversified portfolio of fixed-income options (including both cash and bonds) can be to the advantage of many an investor. Still, their inclusion should likely come after one determines an appropriate allocation to both equities and safer (and more stable) US-government securities. If one ends up with plenty of tax-friendly investment space and desires further diversification, well, Jack Bogle and others already recommend Total Bond Market funds (which have non-Treasury bonds included), so there may be good reason to look beyond TIPS and Treasuries in some cases.