What is Your Need for Fixed-Income Diversification? - dummies

What is Your Need for Fixed-Income Diversification?

By Russell Wild

Diversifying your bonds is still a very good idea. As you know, some stocks can double or triple in price overnight, while others can shrink into oblivion in the time it takes to say “CEO arrested for fraud.” Unless you are investing in individual high-yield bonds (not a good idea), your risk of default — and the risk of your investment shrinking to oblivion — is minimal.

Although you can minimize your risk of default by simply buying Treasury and U.S. agency bonds, you still incur other risks by having too concentrated a bond portfolio.

Diversify by maturity

Regardless of whether you invest in Treasuries, corporate bonds, or munis, you always risk swings in general interest rates (which can depress bond prices) and reinvestment risk (the fact that interest or principal invested in a bond may not be able to be reinvested in such a way that it can earn the same rate of return as before).

Both risks can be greatly ameliorated with the fine art of laddering, or staggering your individual bond purchases to include bonds of differing maturities.

Diversify by type of issuer

In addition to diversifying by maturity, you also want to divide up your bonds so they represent different kinds of bond categories, such as government and corporate. This is true with both individual bonds and bond funds. Different kinds of bonds do better in certain years than others. Holding various types of bonds helps to smooth out your total bond portfolio returns.

Take two years — 2008 and 2009 — as examples.

The year 2008 was an extraordinarily bad year for the economy, and the stock markets worldwide plummeted. Investor confidence fell, and fell hard. As is always the case in hard economic times, money rushed to safety . . . primarily U.S. Treasuries.

At the same time, inflation came to a standstill. Interest rates also fell, as the Fed attempted to pump-prime the failing economy. All of this meant good times for owners of conventional Treasuries and U.S. agency bonds, whereas other bondholders didn’t fare quite as well. That year, from January to December, we saw the following returns:

  • Long-term conventional government bonds: +25.8 percent

  • Investment-grade corporate bonds, all maturities: +8.8 percent

  • Treasury Inflation-Protected Securities: –2.40 percent

  • Municipal bonds, all maturities: –2.47 percent

By 2009, investor confidence had improved, the stock market shot up, the yearning for a safe harbor dissipated, and inflation was back in the picture. Many investors bid au revoir to Treasuries and moved back into stocks and higher-risk, higher yielding bonds. Munis and corporates fared better that year than Treasuries, except for inflation-protected securities, which led the pack:

  • Treasury Inflation-Protected Securities: +11.4 percent

  • Municipal bonds: +12.47 percent

  • Investment-grade corporate bonds: +3.0 percent

  • Long-term conventional government bonds: –14.90 percent

Generally, investment-grade corporate bonds do better than government bonds when the economy is strong. When the economy is in trouble (and people flock to safety), government bonds — especially conventional long-term Treasuries — tend to do better. If you think you can tell the future, buy all one kind of bond or the other. If you are not clairvoyant (you’re not), it makes the most sense to divide your holdings.

Diversify by risk-and-return potential

The returns on high quality corporate bonds, Treasuries, and munis (after their tax-free nature is accounted for) generally differ by only a few percentage points in any given year. (The years 2008 and 2009 saw unusually high spreads, given the tumultuousness of the times.) But some other kinds of bonds, such as high-yield corporates, convertible bonds, and international bonds, can vary much, much more.

In general, because the potential return on stocks is so much higher than just about any kind of bond, many favor stomaching volatility on the stock side of the portfolio. For some people, however, more exotic, “cocoa-bean” type bonds make sense.

High-yield bonds, for example, act like a hybrid between stocks and bonds. Because of this hybrid nature, they make particular sense for relatively conservative investors who need the high yield but can’t take quite as much risk as stocks involve.

Emerging-market bonds (issued by the governments of lesser developed countries) also can produce very high yields but can be very volatile. Unlike U.S. high-yield bonds, they tend to have limited correlation to the U.S. stock market. For this reason, it’s often a good idea to include a small percentage of emerging-market bonds in many people’s portfolios.

Diversify away managerial risk

It’s suggested that you put most of your bond money into index funds: funds run by managers who work on the cheap and do not attempt to do anything fancy. But occasionally, taking a bet on a talented manager may not be such a terrible thing to do.

And regardless, you may turn your nose up at index funds anyway. You may attempt to beat the market by choosing bond funds run by managers who try to score big by rapid buying and selling, going out on margin, and doing all sorts of other wild and crazy things.

Whenever you go with an actively managed fund (as opposed to a passively managed fund, otherwise known as an index fund), you hope that the manager will do something smart to beat the market. But you risk that he will do something dumb. Or, perhaps your manager will get hit by a train, and the incompetent junior partner will wind up managing your fund. That is called managerial risk.

Managerial risk is real, and it should always be diversified away. If you have a sizeable bond portfolio and are depending on that portfolio to pay the bills some day, you shouldn’t trust any one manager with that much responsibility.

According to Morningstar Principia,

  • The ten-year cumulative return on the well-run Loomis Sayles Bond Fund is 169.08 percent (meaning $10,000 invested 10 years ago would now be worth $26,908).

  • The ten-year cumulative return on the not-so-well-run Oppenheimer Champion Income fund, Class C is -58.46 percent (meaning $10,000 invested 10 years ago would now be worth $4,154).

If you’re going to take a shot at beating the market by giving your bond money to managers who tinker and toy, do it in moderation, please.