Just as with any investment type, diversification is key to building a strong bond portfolio. Bonds don’t get as much attention as stocks, but these assets can generate steady returns: A mixed collection of them can minimize risks while maximizing profit. Creating a diverse portfolio of bonds can keep your finances growing while also helping investors weather negative market shifts like economic downturns.
This guide will give you the basics to help you build a strong bond portfolio as well as improve your overall investment strategy.
Defining Bonds and Bond Portfolios
Bonds are a type of financial asset, with their investors loaning money to the government or businesses for an agreed-upon period of time. The borrower promises to return the money on a set date with regular interest payments. Here are some facts to keep in mind about bonds:
- Bonds can be in mutual funds or private investing.
- Bond prices as well as interest rates may change while the investor holds the bonds. Those prices and interest rates rise and fall with market fluctuations.
- However, the borrower still has to pay out 100% of the principal at the time of maturity.
- You receive fixed income from the borrower over the bond’s life, which turns them into a relatively safe investment strategy.
- Some bonds are categorized as high yield, and high yield bonds may come with more credit risk than others.
- All asset investments are given an investment grade, and that includes bonds.
- Bonds investments provide relative security, which makes them an integral ingredient of a strong portfolio.
- They help balance risks out over time. For example, during economic downturns when the stock market plummets, you can weather the storm with the bond payouts.
- By comparison, long-term United States government treasury bonds earn an average of 5% to 10% in annual returns.
A bond portfolio consists of different types of bonds offered by various businesses and governments. Bond interest payments can be used to hedge risks of other investments or as supplemental income to boost your total return.
It’s important to understand risk and return before investing in any asset to avoid unexpected short-term and long-term impacts to your finances. A wealth manager can help you walk through any intricacies of those that may be appropriate for your bond investments to make sure you end up with a diversified portfolio.
3 Types of Bonds
Numerous types exist in the bond market, with the most common being corporate, government, and municipal bonds. Each is given an investment grade that considers quality, risk, past performance, and more. Here are some of the basic details a potential investor would want to keep in mind to ensure a diversified bond portfolio:
- Corporate Bonds
Corporate bonds are issued by public and private companies that need money for corporate projects. Credit rating agencies grade corporate bonds and publish the results as a bond index, helping to inform investors of the credit risk (including risk of default), past performance, projected future results, asset allocation, asset class, and so much more.
- One thing to consider is that you are lending money to a company, not the government.
- You may want to take a look at the space the company occupies before making a decision on whether to contribute to bond funds.
- Some emerging market (or emerging markets) companies may be higher risk than others, for example, which can impact total return.
The lending process works the same way, however: An investor receives an agreed amount of interest regularly until the maturity date arrives. At that time, they get the principal back.
- Government Bonds
These bonds are issued by the U.S. Department of Treasury. An investor’s money goes toward financing the operation of the U.S. Federal government. These bonds are subject to federal tax, but are exempt from state and local taxes. Four types of U.S. government bonds exist:
- Treasury bills (T-Bills) — maturity time: 1 year or less
- Treasury notes (T-Notes) — maturity time: between 2 and 10 years
- Treasury bonds (T-Bonds) — maturity time: between 20 and 30 years
- Treasury Inflation-Protected Securities (TIPS) — bonds indexed according to the inflation
Maturity time is important when determining which bonds to add to your portfolio, as it determines when a bond investor will get their invested funds returned. A wealth manager can help you determine how to stagger your bonds to ensure your maturity dates make sense for your financial goals.
- Municipal Bonds
Municipal bonds are issued by states, cities, and counties and are generally used to fund local projects. They work the same way as a government or corporate bond, with each having a unique investment grade, fluctuations in credit risk, and short-term and long-term implications.
Pro tip: It’s important to keep municipal bonds in a different (tax-exempt) brokerage account than your other bonds because the interest payouts are generally exempt from federal income tax.
Your wealth manager can help you make sure you are aware of any facts like this that put you at risk for paying too much or too little on your income tax return.
9 Things to Know About Building a Diversified Bond Portfolio
When you are starting out, building a bond portfolio may seem complicated. These tips can help you make better investment decisions and ensure you are prepared should prices fall or your income shift.
1. Identify why you are investing in the bond market.
Some people may choose to invest in bonds because they have extra funds and want to be altruistic for governments and corporations who need funds. Others may be hoping to create a career as a bond market broker dealer, and still others may simply be looking to boost their financial statuses or contribute to a retirement account. Keep your reason in mind because it will dictate whether you go for lower-rated, high-quality, low-interest, tax-exempt, FDIC-insured, fixed-income, or short-term or long-term investments in bonds, among other factors.
2. Bond fund homework is essential.
Before purchasing a corporate bond, study the borrower closely. Examine the company’s old financial statements to identify its ability to repay the debt. Pay close attention to the prospectus, too, as you could discover some surprising issues with the bond fund itself. Not all bonds in the government bond fund are government bonds, for example, which may change how you feel about investing in it. The modern prospectus can discuss the risks involved and describe plans for your money, which will give you a lot of information about risk and potential income opportunities.
Additionally, you should make sure you are reading the most up-to-date bond investment data. Each will include disclosures that say the “information contained herein” should be as accurate as possible, but that data will change with time. Be sure you are looking at the most recent information.
3. Diversification is a must-do to maximize your total return.
An ideal bond portfolio should include each common bond type — corporate, municipal, and government — to ensure you have the lowest risk of losing your bond investment funds. Other things to diversify by:
A well-diversified portfolio requires making a significant investment, since bonds are usually sold at $1,000 increments. If you don’t have a suitable budget, you may want to consider exchange-traded fund (ETF) investing instead. You’ll want to speak with your wealth advisor about whether bonds provide the right opportunity for you.
4. Bond ladders reduce investment risks.
When diversifying your bond portfolio, consider building bond ladders. This involves buying those with different maturity dates. Each step of the ladder represents a bond with different maturity, which gives you a better chance for higher yield over time and a lower rate of risk. For example:
- A four-year bond ladder contains bonds that mature in one, two, three, and four years.
- When the first year bond matures, you reinvest the proceeds in a new four-year bond.
- This way your portfolio always has one-, two-, three-, and four-year maturities.
Such ladders create a steady flow of income and reduce the risks associated with interest rate fluctuations. This creates a higher quality portfolio of bonds that may increase your chances of high returns — even if prices fall for a period.
5. Some bonds are right for you, others aren’t.
The bonds in your portfolio depend on your needs and goals:
- If you want a steady income for retirement, low-risk government bonds should be prioritized.
- If you need to maximize your potential income, consider high-yield corporate bonds.
- If you want to avoid paying federal taxes, add more municipal bonds to your portfolio.
Ideally, you should consult a bond expert to identify the right bond mix and maximize portfolio performance. Keeping an open mind about diversified bond opportunities in the short term may lead to high quality results in the long run.
6. Avoid focusing on high-yield bonds.
One of the most common mistakes bond investors make is reaching for yield. They do it when interest rates seem low, as it seems like the bonds may create higher opportunities for income. Higher yields are always tempting, but the risk isn’t always worth it because they may lose value more easily. They are usually offered by bonds with low credit qualities, which could mean greater risk for default, lower yield, and other problems.
Rule of thumb: High yields = high risks. High quality = lower risks and possibly lower yields.
7. Be careful about investing in foreign bonds.
While investing in foreign bonds can diversify your portfolio, doing so comes with certain risks. Your assets are under the control of a foreign government, for example, and that entity can seize them at any time. Before investing in such bonds, make sure to do extensive research about the possible complications and speak with your wealth management advisor.
8. Be careful not to misjudge the bond market risks.
Overall, bonds are a rather safe investment option than many stocks, especially when investors work with the U.S. government. However, assuming that they are 100% profitable is a mistake. Interest rates can be highly volatile, for example, which can reduce the income you may be hoping to achieve. Meanwhile, companies could go bankrupt and complicate debt repayment or eliminate your income opportunities entirely. Being aware of the risks before committing your funds to a bond can go a long way toward mitigating shocks down the road.
9. Don’t overlook the fees.
When investing in bond funds, you are subject to fees and commission. Many investors ignore them when researching prices, yields, and dividends, but high fees could affect your returns substantially and possibly even wipe out large chunks of your projected income. Coupled with taxes, they can minimize your regular payouts and make your investment in bond funds not worth the effort.
The Bond Market Investment Takeaway
Bonds are relatively safe components of your portfolio, especially compared to stocks. They provide relatively fixed income, which means you can add them to your financial list to boost your income and hedge against investment risks related to said stocks.
The returns for bonds are usually lower than with stocks, however. That means you should implement solid diversification and risk mitigation tactics to build a strong bond portfolio and give yourself a better chance of maximizing your funds.
If you need expert advice on building your bond portfolio, don’t hesitate to contact Bogart Wealth! Our experts are always available to answer your bond-related questions and help you adjust your investment portfolio strategy.