Bonds can provide income and offer stability to a portfolio, qualities that make them especially valuable to retirees and others prioritizing cash flow over growth. But investors will often need more than one or two bonds to create a bond portfolio that meets their needs. While it may take serious work and know-how, investors have a few time-tested strategies for building a bond portfolio.
What are the key risks of buying bonds?
Like any investment, bonds present investors with a number of risks to watch out for and the key risks can be broken down into a few main areas:
- Interest-rate risk: The price of bonds is affected by moves in interest rates. Higher prevailing interest rates make the price of bonds fall, while lower rates increase the price of bonds. And the longer the bond’s maturity, the more affected it is by changes in rates.
- Reinvestment risk: Investors must deal with the risk that they may not receive as high a rate on a future investment as they receive on the current bond when it matures.
- Credit risk: While bonds are lower risk (relative to stocks), they still present the risk that the issuer will not be able to make the interest payments or repay the bond when it matures. This risk is also sometimes referred to as default risk.
- Liquidity risk: The bond market is generally less liquid than the stock market, meaning that an investor may not be able to buy or sell a bond at all or at least without significantly moving its price. The bid-ask spread on the bonds may be significant, meaning that it may cost a lot to transact, though U.S. Treasury securities usually remain highly liquid.
Investors building a bond portfolio look to mitigate these risks by carefully purchasing their bonds.
Top strategies for building a bond portfolio
Below are five popular strategies for building a bond portfolio, including how they work and the key risks that they mitigate.
1. Buy-to-hold
The simplest strategy to implement is the buy-to-hold strategy, and as its name suggests, you buy a bond and then hold it until maturity. You’ll receive the stated interest payments over the life of the bond and then the face value of the bond when it matures.
Advantages: You’ll eliminate liquidity risk with this approach, and interest-rate risk becomes a moot point — as long as you hold to maturity. However, if you have to sell the bond, interest-rate risk may become realized if prevailing rates are higher than when you purchased the bond.
You’ll still run reinvestment risk with this approach, though you can reduce credit risk if you purchase bonds from multiple issuers or from high-quality issuers.
2. Bond ladders
A bond ladder is one of the most popular investment strategies and helps mitigate some of the key risks of bonds. In a bond ladder, an investor buys bonds with staggered maturities – say, one year, two years, three years and so on – and when a bond matures, the principal is reinvested at the top of the ladder. In a year’s time when the one-year bond matures, the capital is reinvested in the longest maturity, and the formerly two-year maturity now has one year remaining in its life.
Advantages: The strategy minimizes reinvestment risk since you’re regularly reinvesting over time. If rates rise in the future, you’ll capture some of that with your new bond purchases, and if rates fall, then you won’t be investing too much in the lower-yielding maturities.
You’ll still run some interest-rate risk with this strategy, though the effect of rates on near-term bonds will be muted, reducing overall risk. If you’re generally holding bonds to maturity, you’ll eliminate liquidity risk, and you can mitigate credit risk by buying bonds from various issuers.
3. Bond barbells
A bond barbell does what its name indicates: It has short-term bonds and long-term bonds and nothing in the middle. As the bonds mature, the capital can be reinvested in either short- or long-term bonds, based on the investor’s needs or what the market currently offers.
Advantages: This strategy helps mitigate reinvestment risk by giving the investor the ability to invest in short-term or long-term bonds, depending on prevailing rates when it’s time to reinvest.
If rates are higher at maturity, investors can go with short- or long-term maturities, while if rates are lower, investors can opt for higher-yielding long-term maturities on that side of the barbell. Of course, reinvesting in longer maturities exposes investors to increased interest-rate risk, too.
If the bonds are held to maturity, then the investor can mitigate liquidity risk, and investors can lessen credit risk by purchasing bonds from various issuers to create the bond barbell.
4. Bond bullets
Bond bullets are a less common strategy but may be useful in managing an investor’s financial needs. With a bullets strategy, you buy bonds over a period of time with maturities of roughly the same time period. For instance, if you needed capital in five years, you would purchase a bond today that matures at that time. Then in a year, you buy a bond with a four-year maturity, and so on. At the end of five years, your five bonds would mature and you’d have all your principal back.
Advantages: This strategy helps you have ready cash available at a specific point in the future while helping you to maximize the return over a full time period. Because you’re aiming to have cash available at a specific time and you’re holding to maturity, you can avoid interest-rate risk.
Reinvestment risk may be moot, depending on exactly what you intend to do with the cash. However, if you intend to reinvest that cash in the future, having a bunch of bonds mature all at the same time actually increases your reinvestment risk, piling up cash that must be put to work.
Liquidity risk is moot with a bullets strategy because the point is to hold the bonds to maturity and have cash at a specific point in the future. Of course, if you do need the cash earlier, you may have liquidity risk. You can reduce credit risk by purchasing bonds from various issuers.
5. Bond ETFs
A bond exchange-traded fund (ETF) can use different portfolio strategies that can be tailored to each investor’s needs. Some funds may purchase only short-term bonds, reducing interest-rate risk but increasing reinvestment risk. Others may hold bonds across the spectrum of maturities, reducing the risks of reinvestment and interest rates.
Other funds focus on the higher-risk, higher-return world of high-yield bonds, while other funds focus on lower-yielding, tax-free municipal bonds.
Advantages: A bond ETF allows you to buy the “slice” of bond exposure you want, and bond funds typically have well-diversified exposure to issuers, reducing credit risk. Other risks depend significantly on the type of bonds in the fund. For example, the best bond funds for falling interest rates may work great in that scenario but be fully exposed to other risks such as rising rates.
Bottom line
The bond market is generally not as liquid as the stock market, meaning it can be more difficult for individual investors to buy and sell. For this reason, bond ETFs present an attractive way for investors to get diversified exposure to the credit market while mitigating many significant risks.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
Read the full article here
