Bond diversification: Reduce risks and improve returns
In light of continued pressure on interest rates rising, and the flat to negative performance of most fixed income holdings in the last year, revisiting bond diversification as a tool to reduce risks and improve long term fixed income returns is timely.
Diversification is one of the golden rules of successful investing. When you divide your investment portfolio between the three main asset classes — cash, stocks and bonds — you can balance the risks and rewards of investing. Similarly, many investors should manage risk even further by diversifying the stock positions in your portfolio among different regions and economic sectors.
With the continued potential of rising interest rates there’s another, lesser-known way you can use diversification to your advantage — diversifying your bond holdings. Here’s why you should consider this investment strategy for your portfolio:
1. Manage the risk of interest rate fluctuations.
Interest rate fluctuations have an impact on the market value of your bonds. When interest rates go up, bond prices go down and vice versa. If you always knew which way interest rates were going, your choices would be simple. You would invest in longterm bonds when rates were declining and shortterm bonds when they were rising. But this is a guessing game because no one can accurately predict the future direction of interest rates.
The best solution is to remove the guesswork and hold a variety of bonds, or fixed income type investments, with different yields and maturities. You probably won’t hit a home run with this approach, which is designed to provide more consistent returns. However, you can significantly reduce the risk of underperformance. You may find that there are opportunities that arise in a changing rate environment that make it prudent to sell bonds before they mature.
2. Reduce risk of default.
Each bond is rated for its credit risk. Often, loweryielding government bonds have a lower credit risk, while higher-yielding corporate bonds have a higher credit risk.
To gain exposure to the higher return potential offered by corporate bonds, the best strategy is to diversify among a larger number of corporate issuers. This provides all the benefits of receiving higher returns while dramatically reducing the risk of losses related to default by any one corporate bond issuer.
3. Have exposure to bonds from different countries.
Each government will have different monetary policies that will affect their currencies and interest rates. By having exposure to these other countries you may benefit from their improving economies. Asia in general is a place of potentially massive growth.
The risks of foreign bond exposure must also be treated like any other investment in a foreign country. There are political and economic risks that must be understood because as most of us know, Canada is very different than a country like China.
Each strategy has different risks and may not be suitable to all investors, but by using the time-proven strategy of diversification with the bond component of your portfolio, you can reduce the risk of portfolio underperformance.
A. Craig Elder, CFP, FCSI, CLU, TEP is the branch manager with RBC Dominion Securities Inc. in Medicine Hat. RBC Dominion Securities is part of the RBC Financial Group, member CIPF. For more information on this and other financial strategies contact an advisor at 403-504-2700.
Craig Elder Financial Focus