Portfolio diversification is a strategy that helps investors manage risk. Investors often choose to diversify among industries for stocks, for instance.
But they also consider diversification within different assets types. Bonds are an alternative to stocks that can provide for diversification, if you understand how to use them.
Should you consider adding bonds to your portfolio? Most investors don’t understand bonds as well as they do stocks. This makes it challenging to add them to a portfolio.
Let’s break it down.
Bonds are a class of investments known as fixed-income securities. They are essentially loans, typically created by non-bank entities. They can be used by governments and businesses to raise capital.
A bond is essentially an agreement that gives the bondholder a steady stream of income over the duration of the contract. Bondholders provide an initial payment to the lenders. The lenders agree to pay the initial payment back in the future, along with interest, usually according to a schedule.
This schedule can be monthly, quarterly, or yearly. But other arrangements are possible.
For instance, a zero-coupon bond has an initial payment at a deep discount. The bondholder then receives the face value of the bond at maturity. There are no coupon payments in between.
As simple as the concept seems, bonds can be surprisingly complex. This aspect could be the reason why some investors avoid them.
Bond pricing is the component that makes the investment class complex. They are repriced frequently. Investors looking to close out their positions will need to account for this repricing.
There usually is no complexity involved with holding bonds to maturity. Investors buy the bonds, collect their coupon payments, then receive the final coupon payment and the original investment at maturity.
Market conditions and companies change, though. These conditions are what cause bonds to be continually repriced. The repricing takes into account the risks associated with the changes.
For instance, you may purchase a bond from a stable company. A few months later the company announces new management, which introduces risk to your bond. You may reevaluate owning this bond in terms of that risk.
Of course, stocks can be risky too. That is the point of using diversification of assets. However, adding different asset classes may not be enough to provide proper diversification of a portfolio.
Investors must consider the correlation of assets to ensure they provide the diversification necessary to account for risk.
For example, if you buy a stock and bond in a particular company both assets will fall in value if the company liquidates and goes out of business. This is an extreme case, but it is possible.
Impact of bonds today
If you decide to add bonds to your portfolio, bond mutual funds or bond exchange-traded funds (ETFs) can offer diversification. Most bond funds invest in multiple securities within their asset mix.
For bond funds, they would include several bonds, perhaps in different industries.
It pays to analyze the holdings of any fund you choose. You will find this information on the fund’s website. You can also call the management to learn more about the goals of the funds and match that with your investment goals.
Traditionally, portfolio allocations change according to age. As younger investors have more time to recover from losses they often invest a larger percentage of their portfolio in stocks.
As people age, the percentages for stock should decrease. But how much of the reallocation should be placed in bonds?
Older investors will typically add higher percentages of bonds to their portfolios. However, inflation can cause bonds to underperform. Therefore, investors who feel inflation is going to rise should consider bond alternatives.
Some may want to consider some allocations in gold or silver or even cryptocurrencies, or at least own Treasury Inflation-Protected Security (TIPS) bonds.
If you decide to add individual bonds into your portfolio, learn about how they work before taking the plunge. Bonds tend to be less popular than stocks, at least for retail investors.
There isn’t as much information or resources available as there is for stocks. If you’re going to own them directly instead of through a fund, consider taking an online course or two to become familiar with how they work. Or opt for the services of a bond trading firm.