By David Koch, CFP®, AIF®, CFA, Senior Wealth Advisor
If you’ve made it this far, give yourself a pat on the back. This is my final post on What is a Bond, and we’re going to talk about the only free lunch in town, that’s right, diversification.
Just like you wouldn’t buy a bunch of one stock and call it a portfolio, you wouldn’t buy just one bond and call it a portfolio either. It is just as important to diversify your bonds as it is to diversify your stocks. There are several dimensions in which you may consider diversifying your bond portfolio which we’ll cover here: sector, geography, quality, and maturity.
Goals of the portfolio
When building a portfolio of bonds, you need to pay attention as to the purpose of the portfolio. A bond portfolio can serve many functions; this could be to preserve capital in which case you would want both very low credit and duration risk. The purpose of a different portfolio could be to generate income in which case duration may be less of an issue than credit risk.
If you are building a portfolio of bonds for a specific goal with known timing, you may consider matching the maturities of the bonds with your anticipated cash needs. When the bonds mature, the principal goes back into your account as cash. For example, you may buy bonds that mature in March if you know you’re going to need funds for taxes in April.
If you have an opinion on which way interest rates might move, you may adjust your duration accordingly. If you think interest rates are going to go down you would want to have more duration in your portfolio; likewise, if you think interest rates are going to go up you would want to reduce the duration in your portfolio.
Sector diversification is important because many issuers in a specific sector may all do poorly at once. Energy, for example, was decimated in 2020 because of the collapse of oil prices and the lack of demand. You therefore want to be diversified across many sectors.
Geography is important because sometimes economic slowdowns are isolated to specific regions, and to mitigate the impact of a natural disaster as well. You may want to diversify your bonds across the quality spectrum; high quality bonds are safer but pay a lower interest rate. Lower quality bonds have more risk of default but pay a higher interest rate. Diversifying across sectors, geographies, and quality help mitigate your credit risks.
Diversifying across different maturities is also important. If none of your bonds mature, for example, for 10 years or more, then you would be highly susceptible to changes in interest rates. If all your bonds mature in the next 12 months, you’re likely not picking up much yield (short bonds don’t tend to pay as much as long bonds), and you would be continuously having to reinvest the cash from when they mature. Diversifying across maturities mitigates some of your interest rate risk.
Structures of Maturities: Bullets, Ladders, and Barbells
Here are three common terms for how you may structure your maturities. A bullet structure does not spread them out at all. All your bonds mature at about the same time; this could be in 10 years or 1 year, but they all mature roughly together. This will be highly sensitive to that same interest rate (the 10-year, for example), but not others. This would be appropriate if you wanted to fund a specific goal at a specific time in the future – say you wanted to buy a vacation home in 3 years, then all the bonds would mature and your funds would be available to deploy.
A ladder spreads them out across the curve. A 10-year ladder, for example, will have 1/10th of the portfolio maturing in each year across 10 years. This spreads out your interest rate risk across the yield curve. This can be helpful because when rates move, not all rates tend to move together. The Fed, for example, can manipulate the short end of the yield curve, but the market largely drives the long end. A ladder would be appropriate if there were continuous cash needs, or if you didn’t have an opinion on which way interest rates were going to move.
A third common maturity structure is called a barbell. This type of portfolio would have half the bonds with short maturity (to mitigate interest rate risk), and the other half with long maturity (to pick up some yield). So, it looks like a barbell, with few or none in the middle. This structure might be used especially if you were to think rates were going to rise. If rates come up, when your short bonds mature, they could be reinvested in the newer, higher yields.
One interesting fact of the bond market is that people don’t typically trade one bond at a time. Bonds trade in groups, called “lots.” A “lot” of bonds could be thousands, or as little as 10, but typically in increments of 5. Buying or selling one bond at a time would be highly unusual.
This matters because if you’re going to build a portfolio of bonds and you’re going to diversify across sector, geography, quality, and maturity you are going to need to invest quite a bit of capital. Let’s say you think you can be pretty well diversified across sector, geography, quality, and maturity with as little as 25 different bonds. If you need to buy a 10 lot for each, you’re going to need about $250,000.
This brings us to bond funds. Mutual funds and ETFs bring not only professional management to the table, but also the ability to diversify across far more bonds than you’re likely able to afford on your own. Some bond funds have thousands of bonds in them which allows them to be highly diversified.
Sure, you could build your own bond portfolio; you could likely run new copper plumbing under your kitchen (if you watched enough YouTube videos), but bond investing is, in my opinion, far more nuanced and opaque than stock investing. Most investors should probably leave bond investing to the professionals. That could mean letting a professional build you a portfolio of individual bonds, or it could means using funds or ETFs, but building a portfolio of bonds, and more importantly, monitoring them takes commitment.
Having said that, if you ‘ve read this whole 5-part series you should have a good foundation for what to look for when evaluating bond funds. Make sure you are looking at the risks – as well as the potential return. The current yield is one of your best gauges for the expected return. Caveat emptor, a bond with a 4% coupon that has been discounted 50% because the market thinks it will default, will have an 8% yield. That’s probably not something you want to buy.
Next, look for average credit quality (or average credit score) and duration. If you’re looking for safety, make sure that average credit quality is AA, A, or possibly BBB. These scores would indicate that the average bond is investment grade (although there could still be some junk high-yield in there). Remember, duration is the estimated change in value with a 1% change in interest rates. If you think rates might go up, investing in a low duration fund would be appropriate, and vice versa.
Bottom line: Since many bond funds have a very specific mandate: e.g., low-duration, only investment grade, high-yield, etc. It also makes sense to diversify among bond funds as well. If you’ve made it through this whole 5-part series, you should have a good understanding of most of this jargon. If you see a fund called “Low Duration,” for example, you’ll know that it is not going to be very sensitive to moves in interest rates.
If you’re not asleep yet, I suppose that I’ve done my job with What is a Bond. I hope that you’ve learned something.
If you missed my first four segments, you can read them here, Part 1, Bond Basics and Bond Jargon, here, Part 2, Types of Bonds, and here Part 3, Credit Risk, and Part 4, Duration Risk.
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