How should you select which bond funds to include in your portfolio once you have decided upon the overall asset allocation (e.g., the percentage of bonds and stocks in your portfolio)? Remember bonds are used as ballast for your portfolio. They often zig when stocks zag. They complement your stock holdings. Despite paying interest on a semi-annual basis, bonds historically have not returned as much as stocks over the long run. They have, however, provided investors with safety and less volatility. And if capital preservation is your goal then bonds are a must part of your overall allocation.
I am a big fan of bond funds (or ETFs) rather than buying individual bonds unless you have a lot of time and/or a lot of money to diversify your bond holdings. Small bond investors (e.g., investors buying less than $250,000 or $300,000 in bonds) must pay a lot to buy and sell individual bonds because they are not as easy to trade as stocks. I like a big bond funds that can diversify your holdings at a very low cost.
So how do you approach which bond funds (ETFs) to use? The approach below can be used regardless of whether your portfolio’s bond allocation is 10% or 80%.
Keep in mind that it is important to diversify your bond holdings just like your stock holdings. In the equity area a diversified portfolio consists of holdings across stock sectors and stock types including large, mid, and small companies in all industries. Companies based in developed international countries as well as emerging markets should be included in a diversified stock portfolio. I also suggested that a portfolio hold each stock type in proportion to the overall market capitalization so that your portfolio mirrors the market. You aren’t taking outsized risks by placing, for example, all your money in small domestic companies when they only represent less than one-third of the overall domestic market. See my blog on how to allocate your equity holdings.
Diversification in the bond area is based on a different set of features: the bond issuer, the length of the bond (i.e., when does it mature), the coupon rate (the rate of interest that it pays), and the credit quality (e.g. risk of default).
1. Who is the Bond Issuer?
High-quality, investment-grade bonds issued by solid governments or corporations tend to be less volatile and have lower coupon rates because their risk of default is low. When the economy is looking shaky and investor optimism fades, investors flee to safety (e.g., US treasury bonds with little risk of default) and high qualify bonds increase in value. When the economy is strong and growing, these bonds don’t pay as much.
US Treasury securities (Treasury bills, Treasury notes, Treasury bonds, and Treasury Inflation-Protection Securities (TIPs)) all have the backing of full faith and credit of the U.S. government. These bonds are the safest type of bond and can be bought directly or through bond funds. They offer modest returns over the very long run, but have a good track record of complementing stocks. For example in 2008 when large domestic stocks dropped 37%, long-term US government bonds rose over 25%. Not enough to make up the stock loss, but certainly a way to soften the blow to your portfolio.
Corporate bonds issued by companies such as Apple or Amgen are not as safe as US Treasuries because they have a higher risk of default, but to compensate for this risk the coupon rate is greater. And the more precarious the company’s finances, the higher the coupon rate paid. Indeed bonds issued by high-risk companies are classified as junk bonds. Junk bond prices often rise and fall with stocks as opposed to complementing them.
Another category of bonds includes agency bonds and bonds issued by U.S. government sponsored enterprises created by Congress. The biggest agency bond issuers are Fannie Mae (Federal National Mortgage Association), FHLB (Federal Home Loan Banks), and Freddie Mac (Federal Home Loan Mortgage Corporate). Bonds issued by these agencies have not defaulted even through the mortgage loan crisis of 2008-2009, although their prices plunged substantially. These are bonds issued agencies that aggregate mortgages and then sell the security. These bonds are considered high quality with little risk of default.
2. When do the Bonds Mature?
The more time until the bond matures and the investor gets their money back, the greater the bond’s price volatility. Generally long-term bonds that mature in 20 or 30 years pay interest at a higher rates than short-term bonds to compensate for the risk of holding the money so long. In other words, with long-term bonds, there is a great change that the principal value of the bond can rise or fall dramatically. Short-term bond prices, by contrast, go up and down much less. Prevailing interest rates (or the expectation of future interest rates) have the biggest effect on the price of long-term bonds. So if you have a bond that is paying 3% and interest rates rise to 4%, your 3% bond won’t be worth as much. You will, however, continue to receive your 3% coupon rate payments until the bond matures.
3. Tax exempt or taxable?
Municipal bonds are those issued by states and localities to fund projects or to cover general governmental obligations. They tend to pay less in interest because the interest that investors receive is tax exempt. But compared to a taxable bond, depending on your income tax marginal rate, can be a wise choice. If you are in the 28% marginal tax bracket, a 3% municipal bond will return 4.17% after taxes (3%/(1.0 – 0.28)). Municipal bonds are good to hold in taxable accounts because their income will never be taxed.
4. Have you Matched Your Bond Holdings with the Components of the Overall Bond Market?
You can use an approach similar to the market capitalization approach for stocks in deciding on the mix of your bond holdings. In other words, your bond portfolio mix can match the proportion of each type of bond issued in the total bond market. The statistics below from the Securities Industry and Financial Markets Association as of Dec. 31, 2014 show the percentage of each type of bond in the overall issued domestic taxable bond market (not including money market securities):
- US Treasuries 38.5%
- Mortgage-backed securities (Fannie, Freedie, GNMA) 26.9%
- Corporate debt 24.3%
- Other 10.3%
These percentages can be guide on how to invest your bond holdings. By doing so, your bond portfolio will not be taking an outsized (or undersized) risk compared to the overall market. Mirroring the market also has the advantage of varying the credit quality of your bond holding, but only to the degree that credit quality varies in the overall market. Many diversified bond funds such as the Fidelity US Bond Index Fund (FBIDX) have holdings that mirror these percentages.
Of course, you also may want to look at the maturity date. If you need use of the money in the short-term, keep more money in short-term bond funds (1-3 year average maturity). If you need money in the long-term, use intermediate bond funds that have an average maturity of 5-7 years. Although I am not a fan of long-term bonds now, it doesn’t make sense to avoid them altogether, especially if they are included in a diversified bond fund.
One final note, it is also a good idea to include a small percentage of international bonds in your portfolio. I would not allocate more than 10% of your bond holdings to international bonds in both developed and emerging markets. These bonds can be very volatile, but they further diversify your bond holdings.
In sum, these four questions can help you get a better understanding of how to diversify your bond holdings.