Bonds provide income and stability to a portfolio, making them especially valuable for retirees and those who prioritize cash flow over growth. But investors often need more than one or two bonds to create a bond portfolio that meets their needs. While it may take some hard work and know-how, investors have some proven strategies for building a bond portfolio.
What are the main risks of buying bonds?
Like any investment, bonds carry a number of risks that investors should be aware of, and the main risks can be broken down into a few key areas.
- Interest rate risk: Bond prices are affected by changes in interest rates: higher interest rates make bond prices lower, and lower interest rates make bond prices higher. Also, the longer a bond’s maturity, the more it is affected by changes in interest rates.
- Reinvestment Risk: Investors must deal with the risk that future investments may not earn as high an interest rate as they will when their current bonds mature.
- Credit risk: Although bonds are less risky (compared to stocks), there is still a risk that the issuer will not be able to make interest payments or repay the bond at maturity. This risk is sometimes called default risk.
- Liquidity risk: Bond markets are generally less liquid than stock markets, which means that investors may not be able to buy or sell bonds at all, or at least not be able to buy or sell them without significantly moving the price. Although bid-ask spreads on bonds can be wide and transactions can be expensive, U.S. Treasury securities typically remain very liquid.
Investors building bond portfolios try to mitigate these risks by buying bonds carefully.
Top strategies for building a fixed income portfolio
Below are five common strategies for constructing a fixed income portfolio, how they work, and the main risks they mitigate.
1. Buy and hold
The easiest strategy to implement is the buy and hold strategy: as the name suggests, you buy a bond and hold it until maturity, at which point you receive a stated interest rate and the face value of the bond.
advantage: This approach eliminates liquidity risk, and interest rate risk isn’t an issue as long as you hold it to maturity. However, if you need to sell the bond, interest rate risk could materialize if current interest rates are higher than when you bought the bond.
Although this approach still incurs reinvestment risk, credit risk can be mitigated by purchasing bonds from multiple issuers or from high-quality issuers.
2. Bond ladder
Bond laddering is one of the most popular investment strategies and can help mitigate some of the major risks of bonds. With a bond ladder, investors purchase bonds with staggered maturities, such as one year, two years, three years, and so on, and as the bonds mature, the principal is reinvested at the top of the ladder. When the one-year bond matures one year later, the principal is reinvested in the bond with the longest maturity, and the previously two-year bond now has one year remaining.
advantage: This strategy minimizes reinvestment risk because you reinvest periodically: if interest rates rise in the future, you earn some of it by buying new bonds, and if interest rates fall, you are less invested in bonds with lower yielding maturities.
While this strategy still involves some interest rate risk, it limits the impact of interest rates on short-term bonds, reducing overall risk. If you hold bonds to maturity, you eliminate liquidity risk, and by purchasing bonds from a variety of issuers, you can reduce credit risk.
3. Bond Barbell
A bond barbell, as the name suggests, is made up of short-term and long-term bonds, with nothing in between. As bonds mature, investors can reinvest their capital into short-term or long-term bonds based on their needs and the current state of the market.
advantage: This strategy helps mitigate reinvestment risk by allowing investors to invest in short-term or long-term bonds depending on the prevailing interest rates at the time of reinvestment.
If interest rates at maturity are high, investors can choose short-term or long-term maturities, and if interest rates are low, investors can choose the higher-yielding long-term maturities on that side of the barbell. Of course, reinvesting in longer maturities also exposes investors to increased interest rate risk.
Investors can reduce liquidity risk by holding bonds to maturity, and they can reduce credit risk by purchasing bonds from a variety of issuers to form a bond barbell.
4. Bond Bullet
A lump-sum bond payment is a less common strategy, but it can help investors manage their financial needs. With a lump-sum bond payment strategy, you buy bonds with roughly the same maturity over a period of time. For example, if you need money in five years, buy a bond today that matures at that time. Then a year later, buy a bond with a four-year maturity. Continue doing this until five years later when you have five bonds maturing and you have received all your principal back.
advantage: This strategy helps maximize returns over the entire life of the investment while having ready access to cash at a specific point in the future. Since you aim to have cash available at a specific point in time and hold it until maturity, you avoid interest rate risk.
Reinvestment risk may not be meaningful depending on how you plan to use your cash, but if you plan to reinvest that cash in the future, having a lot of bonds maturing at once actually increases your reinvestment risk and piles up the cash you have to put to work.
Liquidity risk is not an issue with the bullet strategy because the objective is to hold the bonds until maturity and secure cash at a specific point in the future. Of course, liquidity risk can arise if you need cash sooner. You can reduce credit risk by buying bonds from a variety of issuers.
5. Bond ETFs
Bond exchange-traded funds (ETFs) are available with a variety of portfolio strategies that can be tailored to suit each investor’s needs. Some funds purchase only short-term bonds, reducing interest rate risk but increasing reinvestment risk. Other funds hold a wide range of bonds through maturities, reducing reinvestment and interest rate risk.
Other funds focus on the world of high-yield bonds, which offer higher risks and rewards, while others focus on lower-yielding, tax-exempt municipal bonds.
advantage: Bond ETFs allow you to buy “a portion” of the bond exposure you need, and bond funds usually have well-diversified exposure to issuers, reducing credit risk. Other risks vary widely depending on the type of bonds in the fund. For example, a bond fund best suited for falling interest rates may perform well in that scenario, but may be fully exposed to other risks, such as rising interest rates.
Conclusion
Bond markets are generally less liquid than stock markets and can be more difficult for individual investors to buy and sell. Because of this, bond ETFs offer investors an attractive way to diversify into the credit markets while mitigating many significant risks.
Editorial Disclaimer: All investors are advised to conduct their own independent research into any investment strategy before making any investment decision, and please note that past performance of any investment product is no guarantee of future price appreciation.
