Market Beat: Fixed income strategies
Most investors should have some of their portfolio allocated to bonds or fixed income. As people get older and more conservative, they should increase their exposure to bonds appropriately. Bonds are subject to different types of risk, including default risk, interest rate risk and currency risk for foreign issues.
There are several ways to manage risk in bonds. Interest rate risk can be managed by a variety of strategies. A bond’s sensitivity to changes in interest rates can be measured by a complex mathematical formula known as the duration. The duration of a bond or a bond portfolio tells you how much it will move in price with a 1 percent change in interest rates. If interest rates increase, the price of the bond will fall and if interest rates drop, the bond price will increase.
Laddering is one way to manage interest rate risk. With a laddered portfolio, you will stagger out your bond maturities for several years. Ladders can stretch out for twenty years or more, depending on your goals.
Another common strategy is known as a barbell. With a barbell you’ll have about half of your bond maturities in the short term and the other half in the long term with nothing in the middle. That way you can roll the short-term bonds if rate rise.
The bullet is a strategy that involves buying all your bonds in the intermediate term, about seven to 10 years out. That way if interest rates rise, the time until maturity won’t be that long.
Default risk is something to be concerned about if you want to allocate some of your fixed income portfolio into high yield or junk bonds to get extra income. High yield bonds can be used in the above strategies, but you also may want to consider using mutual funds in the high yield area to get more diversification and lower the default risk.
A recent development in bond investing has been the creation of stated maturity funds. Stated maturity funds are mutual funds that have a set maturity date and allow investors to use bullets, barbells and ladders while having the greater diversification that mutual funds offer.
Adding some foreign bonds to a portfolio is a good way to achieve further diversification, but also adds another type of risk known as currency risk. The foreign currency that the bonds are valued in can fall relative to the dollar.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.