When it comes to building an investment portfolio, bonds play an important role in balancing risk and providing income. However, going a step further to diversify your bond holdings can potentially make your portfolio even stronger.
By including bonds of various types, maturities and credit qualities, you may be more prepared to endure market ups and downs.
Here are four strategies for diversifying your bond portfolio.
4 strategies for diversifying your bond portfolio
A bond is a type of debt security in which a company, government or government agency agrees to pay back the borrower a certain amount of interest over a specified time period. When the bond matures, the issuer repays the borrower the principal amount.
Many investors include bonds in their portfolios because they provide income and offer stability, which makes them especially good for cash growth or retirees looking to avoid the volatility of stocks.
But in order for bonds to provide balance in a portfolio, diversification is key. These four strategies for diversifying your bond portfolio can help you get started.
1. Purchase different types of bonds
Bonds are divided into a few main groups depending on what entity is issuing the bond. Corporate bonds, for example, offer higher yields but carry more credit risk, while U.S. Treasurys are considered some of the safest bonds but provide lower yields. Municipal bonds, on the other hand, offer tax advantages but may not be the best option for everyone.
Different types of bonds also respond differently to market fluctuations. Long-term government bonds like U.S. Treasurys are known to hold up and provide steady income during economic downturns, while corporate bonds are sometimes favored during periods of growth.
Owning several different types of bonds can create a more resilient portfolio that withstands shifts in the economic environment, offering both stability and income.
2. Make sure the bonds have different maturities
Spreading out your bonds’ maturities is also a good idea, because it helps manage interest rate risk and provides consistent income over time. When interest rates rise, bond prices tend to fall and vice versa. This is because newer bonds offer higher interest payments, which makes them more attractive than existing bonds with lower payouts.
In other words, a shorter maturity reduces the period in which interest rate fluctuations can affect a bond’s value. Longer-term bonds, on the other hand, face more risk from changing interest rates because there’s a greater chance that rates will change during the bond’s lifetime, impacting its payouts and value.
By combining bonds of different maturities (also known as bond laddering), you can stagger income and reduce the impact of market volatility on the bonds in your portfolio and maintain a steady stream of income regardless of what’s going on in the broader economy.
3. Check the credit quality of each bond
Including bonds of various credit qualities also helps spread risk out across your portfolio. Investment-grade bonds provide low risk and regular income. High-yield or junk bonds offer higher potential returns but come with elevated credit default risk, meaning the issuer may not be able to pay back the bond holder.
By mixing both types of credit levels — according to your own risk tolerance and investment goals — it’s possible to achieve a blend of security and growth over time.
4. Consider investing in bond funds
Bond funds might be a good option if you’re looking to diversify your bond holdings without having to purchase individual bonds. There are generally two types of bond funds:
- Bond mutual funds: These funds pool together investors’ money to invest in a broad range of bonds. You can invest in a bond mutual fund through a brokerage account or reputable financial institution.
- Bond exchange-traded funds (ETFs): Like any other type of ETF, a bond ETF is a basket of bonds traded on a stock exchange and is usually passively managed.
Both options are a simple way to achieve broad-based diversification across all kinds of bonds with different maturities.
Bottom line
There are plenty of ways to diversify your bond holdings within your investment portfolio. Take time to consider what your individual goals, timeline and risk tolerance are in order to determine which bonds are best for you. Finally, be sure to diversify your holdings across bond types, maturities and credit risk.
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