Not all bond funds behave the same.......
For those of you lamenting the behavior of diversified bond funds in your portfolio, I had the same unpleasant experience. Dodge and Cox Income which has evolved to become my "core" bond fund at over 60% of my bond allocation did a spectacular nose-dive last year and it was the best behave one!
In fairness, the total return for DODIX in 2008 was fractionally positive, so it didn't actually lose money for the year but that is not what I wanted my bond allocation to do during a bear market! At the points where I rebalanced it was also showing a significant loss (for a bond fund). I did not realize that DODIX had eschewed government bonds in favor of corporate bonds - admittedly very high quality corporates. But still, not what I expected. Fortunately, DODIX has recovered very well after the debacle, and continues to rally.
So I as I rebalance going forward, I plan to gradually replace DODIX with Vanguard's Short-Term Index fund VBISX. This is a higher credit quality bond fund and another benefit is the duration fixed at around 2.5 years which I think is a great number for "short-term". Exactly the goal I have for my bond allocation - short-term very high quality bonds.
An AA purist might ask why not only use a government bond fund as the asset class to balance out equities as they are even less correlated? Well, other than the unattractive longer duration of an intermediate fund like Fidelity Government Income FGOVX, my instincts push me so strongly towards more diversification in a bond fund that I just can't quite bring myself to do that. Obviously, I am not a purist! I just needed to find the "right" kind of diversification and duration. VBISX is quite a steady-eddie in spite of owning some corporate bonds. It should still work well for rebalancing against equities.
I've been tracking the relative performance of the three different bond funds for quite a while. Here is a comparative Yahoo chart:
Here is the link to the Yahoo page you can play around with the comparisons and time lines. 2 Year Chart of DODIX vs VBISX vs FGOVX
You can click on the S&P box to also compare equities, but that distorts the chart pretty badly - hard to see anything else with the huge S&P swing.
P.S. Knocking on wood so I don't jinx anything.