How lower-risk bonds can help diversify a portfolio

Markets and Investing

Today's investors face a frustrating dilemma when it comes to portfolio diversification: Traditional investing strategies say to allocate part of your portfolio to fixed-income instruments — like bonds — to balance higher-risk investments, like equities.

“When growth assets don't do well, bonds can kick in and act as a smoothing mechanism over time,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. Yet government bond yields still sit at historic lows, and it’s unclear if returns will rise anytime soon.

Weighing your options

These limited returns have left investors discouraged, and many may be wondering whether to abandon bonds altogether in favor of investments with a greater potential return. While it may be tempting to invest in assets that hold the promise of a higher return, migrating away from bonds could increase the volatility of your portfolio.

Before making any decisions on asset allocation, review your portfolio strategy with a financial professional. Consider timelines, financial goals and desired level of risk — and remember that goals don't change just because the market is in flux. In lieu of total bond divestment, Haworth suggests simply reconsidering the types of bonds in your portfolio. There are several different types of lower-risk bonds.

While it may be tempting to invest in assets that hold the promise of a higher return, migrating away from bonds could increase the volatility of your portfolio.

Types of lower-risk bonds

When looking for bonds to add diversification with a lower risk profile, Haworth suggests choosing from the following options:

  • Government bonds. These are issued by stable governments with strong militaries and powers of taxation, including the U.S., Germany, Japan and Canada.
  • Highly rated high-quality corporate bonds. Global companies with diversified product offerings and a long track record of stability and success.
  • High-quality mortgage-backed security bonds. Bonds for both commercial and residential property mortgages can be good choices for diversification.
  • Bonds issued by government-sponsored enterprises. Organizations such as Fannie Mae and Freddie Mac provide credit and other financial services to the public and function as quasi-government entities.
  • General obligation municipal bonds. These bonds are backed by taxes from the issuing jurisdiction rather than by a specific revenue stream. For example, bonds to build schools, parks or roads are considered “general obligation,” whereas a bond to upgrade a toll road is dependent on revenues from toll payers and thus less predictable.

“Some investors think that if they load up on high-yield bonds, they are diversified, but that’s not the case,” Haworth says. While these types of bonds can add value to a portfolio, often they are as volatile as stocks and won't provide the same type of balance investors are seeking to achieve with lower-risk-rated bonds.

As always, these decisions ultimately boil down to risk management. If you’re looking to maintain the stability of your portfolio for unforeseen events, different types of lower-risk bonds may help you achieve that goal.

Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer's ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issues of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes.