Bond ETFs: The Value of Diversification - dummies

By Russell Wild

To be honest, diversification in bond ETFs, while important, isn’t quite as crucial as diversification in stock ETFs. If you own high-quality U.S. government bonds (as long as they aren’t terribly long-term) and you own a bevy of bonds from the most financially secure corporations, you are very unlikely to lose a whole lot of your principal, as you can with any stock.

But the benefits of diversification are more than protecting principal. There’s also much to be said for smoothing out returns and moderating risk.

Bond returns from one category of bonds to another can vary greatly, especially in the short run.

In 2008, for example, high-yield corporate bonds, as represented by the SPDR Barclays Capital High Yield Bond ETF (JNK), saw a return of –24.68 percent.

That same year, U.S. Treasury bonds, as represented by the iShares Barclays 7–10 Year Treasury Bond ETF (IEF), returned 17.9 percent.

But the very next year, 2009, was a terrible year for Treasurys; IEF sagged –6.56 percent and JNK shot up 37.65 percent.

By owning a handful of bond funds, you can effectively diversify across the map. You can have Treasurys of varying maturities, corporate bonds of varying credit worthiness, international bonds of varying continents and currencies, and municipal bonds from across the nation. Seek safety in bonds. If you’re looking for high returns, go to stocks. The purpose of bonds is to provide ballast to a portfolio.

The purposes served by bond funds are to make your bond investing easy, help you to diversity, and keep your costs low. Just as in the world of stock funds, all bond funds are not created equal. Some Treasury funds are better than others. Some corporate bond funds are better than others. Ditto for funds holding municipal bonds and foreign bonds.