Most investors know that one of the best ways to manage risk in a stock portfolio is to diversify. But ask the average bond investor how to cut risk and the answer is likely to focus on safety: Treasury securities and federally insured CDs. After all, what could be safer than guarantees that come from the federal government?
The problem with this answer is that it ignores reward. When you settle for the highest level of safety, you have to settle for low rates of return (reward) too – and sometimes that reward barely keeps up with the inflation.
Yet another concern is the fact that interest rates don’t stay in one place. When rates are rising, investors with maturing bonds can obtain higher income by reinvesting. But when rates are falling, they face the unpleasant prospect of settling for a lower yield to maintain the same credit rating and target maturity.
One way to solve those concerns is to add stocks to your portfolio. Another consideration is to diversify your bond portfolio across several dimensions, including maturity, safety, and yield. Here are some choices to consider to deal with these challenges.
A bond ladder is a way for buy-and-hold investors to diversify within the same asset class and risk category. The purpose is to soften the impact of rapid changes in interest rates and obtain a smoother flow of cash from interest payments.
The way to construct a ladder is to spread your assets equally among an array of maturities so that only a portion of your portfolio matures in any one year. Instead of concentrating in bonds that mature in six years, for example, you might create a portfolio consisting of bonds that mature in two, four, six, eight, and 10 years. When the shortest bond matures, you use the funds to buy a bond that matures in 10 years. If rates are lower than when you bought your first 10-year bond, you can still enjoy the relatively higher yields of the rest of your portfolio.
Adding Bonds from Higher-Risk and relatively Safe Issuers
Whatever level of safety you prefer, nearly everyone has a price at which taking on more risk makes financial sense. Investment professionals calculate that price based on the difference between the yields of bonds with the same maturity but from qualitatively different kinds of issuers.
These differences are referred to as yield spreads and reflect how much more investors need to be paid to accept the risk of the borrower. As economic conditions change, these spreads change, becoming narrower or wider. When spreads are unusually wide, bond professionals see value on which investors can capitalize.
Adding Geographic Diversity
If you own municipal bonds, are they only issued from inside your home state? While such bonds generally offer the added advantage of exemption from state income taxes, diversifying your holdings to include bonds from other states offers three types of potential benefits: 1) higher yields, 2) better credit quality, and /or 3) exposure to different regional economic risks and opportunities.
The same can be said for investing in the debt of foreign governments. While foreign bonds carry the additional risk of currency exchange rates, for investors with large portfolios, adding small amounts of currency risk can actually reduce the overall volatility of the portfolio.
If you think you could benefit from greater diversification in your fixed-income portfolio, please call.