Key takeaways

  • An effective way to build a diversified investment portfolio is to include fixed-income investments, such as bonds, along with higher-risk investments, such as equities.

  • However, not all bonds are created equal. High-quality bonds will have a lower-risk profile and a negative correlation with equities.

  • Be sure to factor in the average maturity of bonds you’re considering as well. Those with shorter maturities are less sensitive to interest rate changes.

Financial professionals recommend a diversified investment portfolio to help generate more consistent investment performance over time.

One way to achieve effective diversification is to allocate part of your portfolio to fixed-income investments, such as bonds, in order to balance higher-risk investments, such as equities. Historically, bonds as an asset class have not kept pace with the returns generated by stocks, but bonds typically experience less short-term price volatility than stocks. "In times when growth assets like stocks don't do well, bonds often kick in and act as a smoothing mechanism over time," says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management.

"Shorter maturity bonds are less sensitive to the impact of interest rate changes. In an environment of rising interest rates, bonds with longer maturities will typically experience more downward price pressure."

Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management

The role of bonds in a portfolio

“People choose to invest in bonds for different reasons,” notes Haworth. “First, they provide a consistent and steady income stream and the principal is usually repaid when the bond matures. A second reason bonds help a portfolio is that in most environments, if the economy slows, interest rates tend to fall, which boosts bond prices.” That positive price action, says Haworth, often helps “smooth the ride” for investors by mitigating some of the volatility inherent in owning equities. Equities prices tend to fluctuate more in periods when the economy is challenged.

It’s important to note that this is not always the case. For example, in the early months of 2022, major stock indices experienced a correction (a decline of 10% or more of value). At the same time, interest rates rose, resulting in lower prices for bonds. This is a rare circumstance when bond performance did not help offset a negative turn in the stock market. “In most periods, we’ll see a somewhat opposite correlation between bonds and stocks,” says Haworth.

One rule of thumb is that a diversified portfolio should contain 60% in equities and 40% in fixed income investments. Keep in mind, however, that this is a broad guideline, and the specific mix in your portfolio should be based on your own objectives, investment time horizon and risk tolerance.

 

Bond quality matters

An important consideration when seeking to diversify a portfolio with bonds is that not all bonds are equal. “Some investors think that if they load up on high-yield bonds, they’re diversified, but that’s not the case," Haworth says. While these types of bonds can add value to a portfolio, they’re often as volatile as stocks and may not provide the balance investors are seeking to achieve.

A better choice to effectively diversify a portfolio that includes equities, says Haworth, is to focus on high quality bonds. Bond issuers from this category of fixed income investments are likely to see the value of their issues hold up better during times of economic uncertainty, when stocks are most susceptible to downturns.

“Quality is a measure of the likelihood of default by a bond issuer, which can include missing interest payments to bondholders or failing to repay principal when bonds reach maturity,” says Haworth. Quality is measured by bond ratings of issuers from independent rating agencies. Investment-grade bonds (those with a lower risk of default) have ratings of or above Baa (on the ratings scale used by Moody’s) or above BBB (on the scale used by Standard & Poor’s or Finch).

 

Bonds to consider for diversification

The following types of bonds come with a lower risk profile. Haworth suggests choosing from the following options to help you diversify a portfolio that includes equities.

  1. Government bonds. These are issued by stable governments from developing economies with the powers of taxation, including the U.S., Germany, Japan and Canada. U.S. government bonds are called Treasury bonds (T-bonds). Many turn to U.S. government securities in times of economic distress, viewing these bonds as a “safe haven.” U.S. Treasury bonds, for example, have never defaulted.
    Because of its taxing authority and the ability to issue debt as needed, the federal government is in the strongest position as a bond issuer. Interest on these bonds is taxable.
  2. Agency bonds issued by government-sponsored enterprises (GSEs). Organizations such as Fannie Mae and Freddie Mac provide credit and other financial services to the public. These bonds are now fully backed by the U.S. government, so they carry credit quality similar to U.S. Treasury debt. Interest on these bonds is taxable
  3. High-quality municipal bonds. Also called “muni bonds,” these are backed by taxes and revenues from state and local jurisdictions. Many well-funded jurisdictions have ample assets and taxing authority to back general obligation (GO) bonds. Revenue bonds issued by providers of essential services such as water and sewer services can be another stable option in the muni bond category.
    Interest earned from most muni bonds is not subject to federal income tax and can be exempt from state and municipal income taxes as well.
  4. Highly-rated, high-quality corporate bonds. Look for well established companies with diversified product offerings and a long track record of financial stability and success. These bonds tend to generate higher yields than government or municipal bonds, but the interest earned is taxable.
  5. High-quality, mortgage-backed security bonds. Also known as mortgage-backed securities or MBS, these bonds are secured by both commercial and residential property mortgages and can be good choices for diversification. These bonds with higher quality ratings tend to benefit from their focus on borrowers with an ability to make timely mortgage payments.

 

Other considerations in building a bond portfolio

Your own views about risk should be a factor in considering how to structure the bond portion of your portfolio. For example, if you’re looking to have part of your asset mix generate higher yields, different types of lower-risk bonds may help you achieve that goal.

Along with quality considerations, it’s also important to assess the average maturity of bonds held in your portfolio. “Shorter maturity bonds are less sensitive to the impact of interest rate changes,” says Haworth. “In an environment of rising interest rates, bonds with longer maturities will typically experience more downward price pressure.”

Before making any decisions on asset allocation, review your portfolio strategy with a financial professional. Consider your investment time horizon, financial goals and desired level of risk. Remember that your long-term goals shouldn’t change just because the market is dealing with short-term volatility.

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