Bond di­ver­si­fi­ca­tion: Re­duce risks and im­prove re­turns

Medicine Hat News - - BUSINESS -

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

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