Investors should diversify bond portfolios like they do their stock portfolios. However, bonds portfolios have a few layers of diversification to consider.
Some investors seem to think of bonds like a famous infomercial: some bond investors just “set it and forget it” when it comes to a bond portfolio. However, there are some important steps in the preparation and maintenance of a bond portfolio.
Diversifying a bond portfolio is just as important as diversifying a stock portfolio, but there are distinct differences in approach.
To diversify a bond portfolio, an investor might first build a ladder. I’m not talking about a stepladder, but a ladder in terms of the length of maturity of bonds. Second, investors might diversify bonds by holding a mix of bond types such as government, corporate, or municipal. Third, and specific to corporate bonds, investors might diversify by credit quality and sector.
By following these few steps, bond investors might be able to gain some diversification and hopefully avoid needing a magical compound to put a portfolio back together.
Are you still building your own bond ladders? Do you follow this method: buy a few bonds here and few bonds there? Well, you can build diversified ladders by understanding some bond principles.
Short-maturity bonds tend to have low coupon payments. Long maturity bonds tend to have relatively higher coupon payments. However, bond prices react differently to changes in interest rates. A bond with a long maturity tends to have greater price fluctuations than bonds with short maturities. Of course, interest rate risk lessens if an investor holds a bond to maturity. If you hold a bond to maturity, the day-to-day fluctuations in a bond's price may not be as important to you. A diversified bond ladder can balance the timing of payments and fluctuations in prices caused by changing interest rates. In short, holding some long-term bonds might give a portfolio higher returns, while short-term bonds can provide some stability.
Depending on the construction, a bond ladder might offer liquidity because an investor can stagger things such that bonds mature at regular intervals. For example, a bond might mature every year, as in figure 1, which illustrates a 10-year bond ladder. TD Ameritrade clients can create a bond ladder using the Bond Wizard.
FIGURE 1: 10-YEAR BOND LADDER.
The ladder has bonds that mature each year; the portfolio is evenly distributed among them. Image source: Investools Income Investing course. For illustrative purposes only. Past performance does not guarantee future results.
Investors may want to also consider diversifying bond ladders by issuer. Bond issuers typically include the U.S. Treasury, municipalities, and corporations. Each bond has its own features and potential benefits and potential disadvantages. Broadly speaking, Treasury bonds, although typically considered the least risk, still carry interest rate risk. Municipal bonds might have some tax advantages, but the interest payments could be subject to Alternative Minimum Tax, and corporate bonds tend to have higher yields than Treasuries and municipals, but the default, or credit, risk is generally more of a factor.
FIGURE 2: DIVERSIFYING A BOND LADDER BY ISSUER.
This ladder is diversified by maturity and bond type. Image source: Investools Income Investing course. For illustrative purposes only. Past performance does not guarantee future results.
But diversification doesn’t end here. Corporate bonds allow investors to choose from various bond qualities. Generally, the lower the credit quality, the higher the yield. Low-quality bonds mean the corporation has an above-average chance of defaulting on a coupon payment, return of principal, or both. These lower-quality bonds are called high-yield bonds. As the name suggests, these bonds have higher yields to compensate for more risk when compared to other corporate bonds with higher credit quality. These corporate bonds are called investment grade. (Learn more about high-yield and investment-grade bonds.)
Investors can also seek to reduce bond portfolio risk by diversifying among corporate bond sectors and industries. Different sectors such as financial, energy, or health care perform differently during economic cycles. This means there are times when higher yields will be available in a sector, but also pose higher risk. For example, the energy sector currently has numerous high-yield bonds because many oil companies have suffered financially as oil prices have fallen. As oil prices stabilize and increase, the credit risk for these bonds will likely decrease.
Does your bond portfolio need a workout or require some cleanup? Now you have the tools to start getting it in shape.
TD Ameritrade offers a wide range of fixed-income investments designed to help meet needs like preserving capital or generating income.
The information presented is for informational and educational purposes only. Content presented is not an investment recommendation or advice and should not be relied upon in making the decision to buy or sell a security or pursue a particular investment strategy.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Investments in fixed income products are subject to liquidity (or market) risk, interest rate risk (bonds ordinarily decline in price when interest rates rise and rise in price when interest rates fall), financial (or credit) risk, inflation (or purchasing power) risk and special tax liabilities. Investments in fixed income products are subject to market risk, credit risk, interest rate risk and special tax liabilities. May be worth less than the original cost upon redemption.
Diversification does not eliminate the risk of experiencing investment losses.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2019 TD Ameritrade.