In a previous post, we discussed how to diversify one’s assets in equities. B&C Financial uses a top down approach to invest in companies across many different industries, which gives you a small amount of exposure in each of those industries to ultimately achieve proper diversification. Now we will discuss how to diversify your assets in fixed income.
There are many types of fixed income such as government bonds, municipal bonds, certificates of deposit, and corporate bonds. First, the goal for owning fixed income must be clear, that goal is always safety. Equity investments are the risk side of your portfolio and fixed income investments are the safety side, where one should be willing to accept less return for the better certainty of a consistent return. So do we own fixed income across all types? Within the corporate bond world should one own bonds across different industries as we do with equities? The answer is yes; the additional diversification is important, however in the fixed income world we are most concerned with two types of risk: credit risk and interest rate risk. Let us start with credit risk.
Credit risk is simply the chance that whomever one lends their money to will not be able to make good on their promise to pay back the money they borrowed. So how can one limit this risk? Certificates of deposit carry a guarantee from the Federal Depositors Insurance Corporation of up to $250,000. This guarantee also allows the banks to borrow money from consumers in this manner at a very low rate. Low risk means low return. The world of corporate bonds offer fair yields depending on the perception of the companies abilities’ to repay their debts. A company carrying an investment grade rating would pay less than a company carrying a rating below that level also known as a junk bond. So if one truly wishes to limit their risk while investing in fixed income and have a proper asset allocation work for them they must avoid taking unnecessary risks with their fixed income investments. In short, invest in investment grade corporate bonds, municipal bonds (in cases where a tax advantage might be had), and certificates of deposits for short term needs. The most important thing to remember is return is not the goal with fixed income but rather protection of capital.
How do we protect against interest rate risk? Diversification within fixed income is not so much related to the type of asset, but is focused on timing of the asset. True fixed income instruments should have a maturity date or a date when the lender is to receive their principal or the face of amount of their debt instrument back. Spreading out your fixed income investments so they mature at different time periods will help limit the chance that one invests all their money to come due at one time hoping their decision is the most optimal for the best interest rate return. To buy a twenty year bond today may be a good decision in the world of interest rates because the interest rate is higher than a shorter term bond, however with interest rates at an all time low the decision also might be a poor one. By spreading the maturity dates out over time one always has money coming due to invest. This will help to get achieve the historic average on returns. Trying to pick a point in time where one thinks interest rates will be optimal leaves too much to chance.
Here at B&C Financial, we use bond ladders (bonds with sequential maturities) to limit interest rate risk and only invest in investment grade bonds that are diversified across sectors in the corporate world. We view bonds as the safe portion of our clients’ assets and also the place to put profits from the equity portion of their accounts in good markets so we do not give their equity profits back. Look to hear more from our department in the future and please email us if there are any topics you would like us to cover.