How and Why To Diversify Into Bonds
November 26th, 2011 by Marc Prosser
Diversification lowers risk. You never want one or two bad investment picks to have a major impact on your portfolio.
Here are a few reasons why an individual bond could lose money and hurt your portfolio:
- If you do not hold a bond to maturity and rates rise between the time you purchase and sell a bond, then you will sell the bond for less than you paid for it.
- If the company or other entity whose bonds you have invested in files for bankruptcy you are likely to loose a large portion if not all of your investment.
- If the bond you have invested in is “called” by the issuer, you are not losing money on the bond but you will likely be forced to reinvest the money on the called bond at a lower rate of interest.
Diversification within your bond portfolio means selecting bonds that are sufficiently different in terms of industry sector, maturity, and type of issuer (government or corporate, for instance.) There is a trade-off between how many different bonds you buy in order to diversify and the time and effort to manage your investments. As an example, picking 15 diversified bonds is an investment strategy that is manageable, but that on average also limits the value of a bond to less than 7% of the value of whole bonds portfolio.
If you don’t have the time or the money to pick a selection of bonds like this, other possibilities for diversification exist.
Bond mutual funds
Professional bond investment managers buy different bonds for the fund and invite investors to buy shares in the fund. Investors are remunerated by a portion of the profits from incomes on the bonds and also benefit from the diversification that the investment managers apply to the fund as a whole. Entering and exiting the bond mutual fund as an investor may depend on bond fund management decisions and the capacity at any given time of the fund to buy back shares.
Exchange Traded Funds (ETFs)
Shares in bond mutual funds may be traded on different exchanges. These exchange traded funds (ETFs) allow investors another degree of investment flexibility, as the shares are traded on a public market, rather than having to be bought back by the fund itself before being resold.
Diversification versus tax benefits
If tax exemption is important to you, you may choose to invest in municipal bonds. Interest income from these bonds is often exempt from federal income tax and also from the income tax of the state in which they are issued. On the other hand for this tax benefit to work to your advantage, the municipal bonds you buy will be issued by entities within the same state and therefore cannot give the same diversification as combinations of other bonds.