5 Ways to Diversify Your Fixed Income Portfolio
March 14, 2013
Historically, investors have spent incredible amounts of time doing research to diversify their equity portfolios. Figuring out just how much should be allocated to emerging markets and small cap can be a never-ending exhausting process. The problem is after all of the time devoted to equities, the standard practice for many investors is to just buy a Total Return bond fund for their fixed income.
Diversifying the fixed income side of a portfolio is just as important, if not more so, than the equities. What if you are using it to hedge against a down market and your bond fund tends to correlate to the stock market? That buoy you thought you put out there to keep you from sinking was filled with rocks and your portfolio is plummeting.
Total Return funds are good core holdings the way Large Cap holdings tend to be cores for equity portfolios. You have to build around that core to create a solid strategy. Here are some different ideas for diversification purposes in fixed income:
1. Treasury Inflation Protected Securities (TIPS)
TIPS are securities that are indexed to inflation to protect investors from the negative effects of inflation. They are backed by the US government and considered a low-risk investment. They can be purchased individually, in a mutual fund form, or as an ETF.
2. High Yield Bonds
These bonds generally have a lower credit quality, which is the reason for the higher yield. They are based on the ratings of the two major rating agencies, S&P (BBB or lower) and Moodyâ€™s (Baa or lower). While this is a riskier investment than a regular bond fund, it is a widely held investment idea, and with the right vehicle, it can create wonderful results. You could expect 150-300 basis points higher in yield from investment grade bonds. Purchasing these investments in an actively managed mutual fund where there is a team of analysts to make sure they donâ€™t buy any bonds in danger of defaulting is a good way to introduce yourself.
3. Floating Rate Bonds
While TIPS help protect you from inflation risk, floating rate bonds help protect against interest rate risk. The rate on these bonds change periodically based on either the Federal Funds rate or LIBOR. This adjustment allows these bonds to perform better in a riding interest rate environment, and who doesnâ€™t think that rates will go up at some point? The downside to these bonds generally shows up in falling interest rate situations as they will under-perform. These can be purchased individually, in mutual funds or by ETF.
4. International Bonds
The same way one would buy international equity, the fixed income side can be used to diversify a bond portfolio. It is pure fact that much of the developed foreign markets have gotten slammed over the past few years. Places like Europe have taken a major beating, but are starting to work their way out of the mess they were in. If you look at their situation, they may be a year or two ahead of the US, and there is a possibility that there will be a great opportunity there.
5. Emerging Markets Debt
Again, with the same theme as above, emerging market debt isnâ€™t the taboo it once was. There are many emerging market countries with solid financials and this is another way to diversify. It is completely non-correlated to the Barclays Aggregate Bond Index and can be a nice added piece to your portfolio.
These ideas are not all that are available. The bond market has become quite different over the last decade. As always, please be sure to do your own due diligence and make sure these investments are right for you. Good luck!
How do you plan on diversifying your fixed income portfolio? Leave a comment!
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