Mention “portfolio diversification” and most investors immediately think of stocks. That’s good, because a poorly diversified stock portfolio can lead to disaster!
However, your bond portfolio also needs to be appropriately diversified. Doing so may help you more effectively balance those two key elements of investing: risk and reward.
Although “appropriate’ diversification means different things to different people, there are six things to carefully consider. We’ll discuss three of them today.
Pay attention to quality! Certain types of bonds, such as Treasury securities, carry a very low risk of default. Since credit quality and yield are inversely related as a general rule, it may be tempting to sacrifice quality at the altar of yield. If you choose to pursue higher yields, spread your risk by diversifying among different issuers.
Think about maturities! As a general rule, longer maturities mean higher yields…and…bonds with longer maturities are more sensitive to interest rate fluctuations. Given the current low rate environment, that’s a major consideration! A risk-averse investor may choose shorter maturities knowing that he or she will settle for lower yields. A more risk tolerant investor may choose longer-term bonds in search of better yields, thus taking on more risk. Staggering or laddering your maturities may be a better strategy.
Don’t ignore your tax bracket! Are you in a higher tax bracket? If so, you may want to consider municipal bonds. As a general rule, municipal bond interest is tax-exempt at the federal level, and if issued in your state or city of residence, it may also be exempt at those levels. Caution – some bonds may be subject to the federal alternative minimum tax (AMT), so don’t forget to have a chat with your tax advisor or Wealth Manager. Many, but not all, municipal bonds have excellent credit quality, so…as noted above…pay attention to credit quality!!!
Next week we’ll cover the final three!