Final bond investment class: Diversification
Over the previous two weeks we have discussed the various types of bonds and how they work. Last week we examined in excruciating detail how bond prices are determined (extra credit if you read all the way to the end). Today we look at the role of bonds in reducing the risk of a well-constructed portfolio.
The concept of diversification is largely intuitive: distributing investment risk among several asset classes so as to reduce the overall risk of the entire portfolio. Generally, we turn to bonds (especially investment grade bonds) to provide a low-risk anchor to tether the other investments in the portfolio. The recommended allocation to fixed income depends upon investor-specific factors such as age, time to retirement and personal level of risk aversion.
Aside from cash, highgrade bonds provide the greatest degree of safety and predictability over time. In exchange for this relatively low risk, they offer very modest returns. This is not to say they are without risk: inflation erodes the real return, and rising interest rates diminish the present value of current bond holdings. But we generally consider the risk of significant capital loss with investment grade bonds to be minimal.
U.S. government bonds, as well as the sovereign debt of other major developed nations, are often considered to be “risk-free” in terms of the likelihood of repayment. Treasury bonds are backed by the full faith and credit of the U.S. government and are assumed to carry infinitesimal default risk. As such, they also offer the lowest rate of return (current 10-year Treasury bonds yield a whopping 2.3 percent, barely above the average inflation rate). Investment-grade corporate bonds benefit from both the stellar creditworthiness of their issuing companies as well as their preferential rank within the pecking order of all investors in the company.
Bond investors enjoy priority over stockholders in the event that financial distress afflicts the issuing company. If the firm’s fortunes deteriorate sufficiently to threaten a liquidation in bankruptcy, bondholders must be repaid first before any remaining assets are distributed to stockholders. This of course is most unlikely with top-tier corporations but is not unheard-of (witness Enron, WorldCom, et al.)
Municipal bonds are issued by state and local governments to finance basic infrastructure projects like sewers, highways and utilities. They carry higher risk than U.S. Government issues, and defaults have occurred (Detroit, Harrisburg and San Bernardino being recent examples). But such defaults are rare and the risk can be further mitigated by seeking bonds with credit insurance and favoring “general obligation” bonds whose payments are not tied to a specific project like an airport or hospital. Muni bonds can offer the additional benefit of federal tax exemption in many instances.
Unless one is very young with many years of employment ahead, devoting a fraction of your investment portfolio to bonds is a prudent risk-management strategy. The precise proportion depends again on many individual factors and is best determined in consultation with your financial adviser. But as a general rule, the proportion of fixed income should increase with age unless your primary objective is not your own retirement income but building a legacy to pass along to future generations. Warren Buffet is fond of observing that his time horizon for investment allocation is 100 years.
Most of us do not have that luxury. A prudent allocation to bonds certainly diminishes the long-term expectation for investment gains. But it also reduces volatility and helps reduce the negative impact of severe market declines. Think insurance: premiums are a dead-weight loss every year until a fallen tree takes out your roof.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.