Similar to stocks, you can build your bond portfolio with mutual funds, exchange traded funds and individual bonds. Unlike stocks, there are advantages to owning individual bonds and CDs instead of funds (to learn of these advantages read our post on the problems with bond funds). The following passages will help you achieve excellent income with safety, regardless of the type of security you use.
Individual bonds
Keep maturities short
Under normal circumstances, yields on bonds get higher when their maturity extends farther into the future. Nonetheless, resist the temptation to garner yield with very long maturities.
First, long-term bonds are very volatile. When rates rise, long-term bonds will drop in value by substantially more than short-term bonds. If you ever had to sell before maturity, the losses could wipe out all previous income.
Second, you may have locked in a lousy rate for a very long time. Even if you think rates might go down, bonds are not for speculative investment. You are more secure and agile in terms of accessing new rates if you buy short and intermediate term bonds. Limit purchases to maturities of seven years or less.
Keep maturities spread out
To reduce risk and maintain flexibility, build your portfolio with bonds of different maturities. You may see the term “ladder” used to describe such a pattern. Some brokerage bond platforms have tools to help you build bond ladders.
For example, as you create a portfolio from scratch you might buy bonds maturing in one, two, three, four, and five years. In a year, the 1-year bond will mature, the 2-year bond will age and become a 1-year bond, the 3-year bond will become a 2-year bond, and so on. If you take the proceeds from the maturation of the former 1-year bond and buy a new 5-year bond, your laddered portfolio will be back to its original one to five-year structure.
You do not have to achieve perfect form. If you can earn more buying a bond maturing in 30 months instead of a similar one maturing in 24 or 36 months, buy the 30-month bond. However, do not put your entire portfolio into the longest maturity of your range simply because the rates at that end are highest. Spread out but be flexible.
Seek investment grade bonds
The bond portion of your portfolio is intended to provide income and reduce overall volatility. You want to buy securities you will not have to worry about. Avoid non-investment grade (a.k.a. ‘junk’ or ‘high yield’) bonds. Instead, seek securities classified as “investment grade” by the major credit agencies. All bonds issued by the U.S. government (a.k.a. treasuries) and government sponsored enterprises (a.k.a. agencies) are so rated. Along with FDIC insured CDs, you should feel very secure investing in treasuries and agencies.
Many corporate bonds are also rated investment grade. Corporates usually offer higher yields than government related bonds, so a little extra work may be worthwhile.
Diversify when not insured by the government
You could put all of your money into a single treasury bond or up to $250,000 into an FDIC insured bank CD without issuer risk concern. Among corporates, even if you limit your holdings to the most secure names, don’t put all your eggs into one basket. Limit exposure in any one company to 5% of your bond portfolio.
Bond mutual funds
Per comments in our post on bond funds, bond mutual funds may not be as effective as individual bonds and CDs. But you may nonetheless need to invest in funds. They may be the only choice in a retirement plan or education savings platform; the asset level in an account may be insufficient for a diversified portfolio; you may prefer simplicity to effectiveness. Whatever your reason, the following comments should help.
Minimize expenses
Expense ratios are the biggest determinant of relative performance between similarly invested mutual funds. This is particularly true of bond funds, where costs can take a big bite out of interest income. When choosing between bond funds of the same maturity range and credit quality, if there’s no compelling reason to do otherwise pick the one with least expense. Related, rule out all funds and fund platforms that charge sales commissions.
Seek bonds you would buy individually
Your bond portfolio should be a source of income and safety. To control risk, limit your fund choices to investment grade bonds with an average maturity less than seven years.
Bond exchange traded funds
Similar to mutual funds, ETFs may not be as effective as direct ownership of individual bonds and CDs, at least in terms of income and stability. Still, you may prefer ETFs or be forced to select such in a platform. The suggestions below should be of benefit.
Minimize expenses
ETFs track the performance of a specific index, minus expenses. If two ETFs track the same index and have very different expense ratios, select the one with least expense.
Seek bonds you would buy individually
As stated previously, your allocation to fixed income should be a source of income and safety. Limit your ETF choices to investment grade bonds with short maturities.
Seek value by paying less for assets
Mutual fund shares transact at the precise net asset value (NAV) of the underlying securities. ETFs transact at a price determined by the market through offers and bids; the same as stocks.
When you narrow down your list of potential bond ETFs, for each navigate to the issuer’s site and look up the net asset value per share. Compare each NAV to the current market price. If the NAV is at or above the purchase price, you should feel comfortable moving forward. If the NAV is less than the price, do not purchase. If no ETFs of the type you seek are available at a fair price, buy a mutual fund in the same category instead.