Smart Strategies
Asset Allocation
Buying bonds can be an important part of an asset-allocation strategy that balances risk and reward. Asset allocation is all about diversification of investments, both within and among different asset classes. In short, it means not putting all of your eggs into one basket.
In putting together a diversified portfolio, you select a mix of stocks, bonds and cash so as to arrive at the risk-reward ratio that stands the best chance of reaching your investment objectives. In general, the longer you have to invest, the greater risk you can assume because you might have the opportunity to ride out short-term market losses in hopes of achieving greater long-term returns. But investing always involves some degree of risk—and risk comes in many flavors: inflation risk, liquidity risk, market risk and so forth.
Remember that your risk analysis will always be unique to you. If you have limited assets or assets that you cannot or are not willing to lose, then you will want to think twice about the risks you take—especially risks that could result in your losing your principal or seeing the value of your investment eroded by inflation.
At least once a year, you should evaluate your portfolio with an eye to rebalancing your mix of stocks, bonds and cash to maintain the percentages you’re comfortable with. For example, if bonds have dramatically outperformed stocks in recent years, you might want to rebalance your portfolio by moving some of your assets (or investing new money) into stocks.
Diversifying Within Your Bond Portfolio
Within the bond portion of your portfolio, you will also want to diversify your holdings. Here are two key factors to consider when determining your bond allocation:
Tax Bracket
Your tax bracket may influence how you allocate investments among taxable and tax-exempt bonds. If your current federal income tax bracket is 28 percent or higher, the tax savings on municipal bonds, for instance, may be worth considering. Tax calculators are available on the Web, including SIFMA’s Investing in Bonds website, to help you determine how tax-exempt yields compare to taxable yields.
Risk Tolerance
Your risk tolerance depends on your own personal preferences as well as the number of years you have until retirement. If you can’t sleep at night because you’re worrying about a downgrade in a high-yield bond, then you’ll want to consider lower-risk alternatives. You might consider diversifying your bond holdings by using a strategy called laddering.
Bond Laddering
Laddering is a strategy that uses “maturity weighting,” which involves dividing your money among several different bonds with increasingly longer maturities, and is frequently recommended for investors interested in using bonds to generate income. Laddering is used to minimize both interest-rate risk and reinvestment risk. If interest rates rise, you reinvest the bonds that are maturing at the bottom of your ladder in higher-yielding bonds. If rates fall, you are protected against reinvestment risk because you have longer-maturity bonds at the top of your ladder that aren’t exposed to the drop.
For example, you might buy a two-year bond, a four-year bond and a six-year bond. If you put approximately equal amounts of money in each bond, the average maturity of the entire portfolio would be four years.
As each bond matures, you would replace it with a bond equal to the longest maturity in your portfolio. For example, when the two-year bond matures, you replace it with a six-year bond. But your older bonds are now two years closer to maturity, so the average weighted maturity of the portfolio remains the same—
four years.
A laddered portfolio is not limited to the maturities described above. You can build a ladder to correspond to longer durations and include longer maturities. Your return would be higher than if you bought only short-term issues. Your risk would be less than if you bought only long-term issues. Laddering also helps you gain a greater degree of interest rate protection than if you owned bonds of a single maturity. If interest rates fall, you may have to invest your bonds with the shortest maturity date at a lower rate, but you’d be getting above-market return from the longer-maturity issues. If rates go up, your total portfolio is apt to pay a below-market return, but you could start correcting when your shorter-term bonds mature.
There is a downside to laddering: Your overall return may be lower than a non-laddered bond portfolio.
Benefits of Laddering
Laddering’s mix of short- and medium-term bonds helps to:
Bond Swapping
As the name suggests, bond swapping involves selling one bond and simultaneously purchasing another similar bond with the proceeds from the sale. Why would you engage in this practice? You may wish to take advantage of current market conditions ( e.g. , a change in interest rates), or perhaps a change in your own personal financial situation has now made a bond with a different tax status appealing.
Bond swapping can also cause you to receive certain tax benefits. In fact, tax swapping is the most common of bond swaps. Generally, anyone who owns bonds that are selling below their amortized purchase price and who has capital gains or other income that could be partially, or fully, offset by a tax loss can benefit from tax swapping. Tax law plays an important role in bond swaps so it is advised that investors consult a tax advisor for the most up-to-date advice.
Reinvestment of Interest Income
Whenever possible—and especially if you have many years before retirement—you should reinvest your bond interest (coupons). If you buy individual bonds, this takes discipline because you need to put each coupon payment you receive to work earning interest rather than spend it. Consider putting them in a brokerage money market account, or even opening a standard savings account just for your coupon payments. At the end of each year, you can put them into the next bond in your laddering strategy.