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.
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