7.2 Bond diversification
This article explores “within asset class” diversification for bonds. Just like the stock discussion in the previous article, I discuss here how to diversify bond holdings and the degree of needed diversification within bond holdings.
How to diversify (individual bonds versus bond funds)
Unlike stocks, when investing in bonds there is greater ability to separate out the risks from catastrophic events versus overall market fluctuations. For bonds, a catastrophic event is called a default, where the bond issuer either can’t make the regular interest payments or fails to repay the bond value altogether. Prices of bonds can also fluctuate similar to stocks, but bond prices are more predictably correlated with changes in interest rates, as discussed in Article 6.2.
The risk of bond defaults can be minimized by investing in high quality bonds; those bonds with higher quality ratings from the bond rating companies. In fact, by investing in U.S. government bonds, almost all of the default risk is eliminated. Similarly, if you want to minimize the price fluctuation risks, you can hold individual bonds to maturity, at which time you are repaid the face value of the bond. Consequently, a range of individual U.S. government bonds can easily serve the needed function of bonds in many portfolios, while almost completely avoiding both price fluctuation and default risks.
So, in the case of bonds, the use of funds as a diversification tool is not as clearly indicated. Although funds can decrease the impact of any given bond default on your portfolio, they can also increase the potential for price declines, particularly when interest rates start to rise as they eventually will. However, there is nothing obviously wrong with using bond funds, and some authors prefer bond funds for some of the flexibility they provide. For example, you could hold an intermediate duration constant maturity bond fund over a period about equal to the fund duration. As shown in this graph from Cullen Roche, even in a rising interest rate environment, such a fund suffers negative returns from price declines early in the holding period, but the returns then recover later in the holding period due to the higher interest payments being generated.
The average annual return in the first year of this example is -4.23%, but by the fifth year the annual return is positive, and would continue to climb, at least for a few years, even if the interest rates flatten. Holding your bond fund investment for a sufficiently long duration is key to this sort of scheme working. If you sell early, then you have simply locked in the early negative returns.
As noted in Article 6.2, the strategies of either using intermediate term individual bonds or bond funds are likely to provide low returns, at least until after interest rates have risen somewhat. But either type of bond investment is unlikely to result in negative nominal returns, as long as you hold them for the appropriate duration. And the big caveat here is that longer duration bonds or bond funds (such as 20 or 30 years) are problematic regardless, because their prices will decrease much more precipitously when interest rates eventually rise.
In sum, it’s the overall lower risk associated with government bonds that makes it less necessary to diversify bond holdings using funds. If government bonds carried risks similar to stocks, then there would likely be more reasons to hold bonds as funds rather than individually. This brings up an important point related to bond quality and risks of default. If you invest in higher yield corporate bonds (or junk bonds) in an attempt to boost your bond returns, the level of risks starts to approximate that of stocks, although the sources of risk still differ between the two asset classes. With corporate bonds, you can moderate some of the higher default risks by investing in corporate bond funds, rather than trying to select individual and potentially more risky individual corporate bonds. However, because of the current interest rate environment, the analysis of stocks vs. bonds in Articles 6.1 and 6.2 suggest that stocks (and now we can more specifically say “stock funds”) are a better choice in the long run if you are seeking higher returns and are willing to accept somewhat higher risks.
Bonds – Diversification within the asset class
Given the likely low future returns for bonds for the foreseeable future, I will not devote a lot of discussion to the question of bond holding diversification. If you have a substantial bond portfolio, a mindful perspective suggests there is certainly no harm in holding a more diverse array of bonds. This could include bonds diversified by: geography (bonds from different countries), type (government, corporate, inflation protected, callable, municipal, and zero coupon), duration (date to maturity), and quality (different bond rating levels). Nonetheless, given the safety of U.S. government bonds, and the relatively lower volatility and returns of all bonds, less diversified bond holdings may adequately fulfill the needed function of bonds in an overall portfolio.
I discussed in the Article 5 series that inflation and taxes are important factors in determining long term returns, and in Article 6.2 I noted that inflation has a direct impact on bond interest rates. Consequently, diversifying bond holdings to buffer against rapid and unexpected changes in interest rates is an obviously mindful approach. This can be accomplished by investing some portion of your bond holdings in government TIPS bonds as discussed in Article 6.2, because TIPS returns are adjusted for changes in inflation and perform particularly well in situations where interest rates rise unexpectedly. For this reason, they are sometimes referred to as an inflation “hedge”. Similarly, income from municipal bonds are free of Federal income taxes, which can boost the “take home” income from a bond portfolio.
If you attempt to boost bond returns by designating some portion of your bond holdings to lower quality, higher yielding junk bonds, it’s logical to maintain some balance of low and high quality bonds. As noted above, allocating too much of your money to high yield bonds, in many respects simply mimics the risk/returns achieved by switching to stocks instead and invalidates much of the purpose of holding combinations of bonds and stocks. This last observation leads directly to the issue of diversification across asset classes, which is discussed in Article 7.3.