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How to Select the Right Mix of Bonds

Bonds belong in every diversified investment portfolio. They can reduce risk levels and smooth the price volatility in any portfolio. Find out how bonds work and how they can benefit your portfolio.
| Money Rates Columnist.
min read

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Many investors know that bonds belong in every diversified portfolio, regardless of its purpose. What's less clear is how to narrow down the field to select the right mix of bonds for your portfolio.

Today, there is a greater assortment of bonds, bond investment types, and strategies than ever before. The U.S. fixed-income market is the largest in the world, comprising about 39% of the $106 trillion securities worldwide, or $41 trillion as of 2019, according to SIFMA.

There's also a number of ways to add bonds to your portfolio. Bond mutual funds and ETFs can deliver an optimal mix of bonds at a low cost. These can be selected using a Robo-advisor that can help create a model portfolio based on your risk tolerance, time frame, and investment goals.

But complexity argues in favor of working with a qualified financial advisor who is experienced in fixed-income selection and trading to streamline the process. Select a money goal below to get a curated list of investment options and a select group of specialists to help you get started.

And beyond that, there's more specific knowledge about bond investing that can help you learn to evaluate investments as you become aware of them working with your financial advisor.

What are Bonds?

Bonds are simply debt obligations issued by borrowers that will be repaid at some specific future date.

When investors buy bonds, they are entitled to payments at regular intervals from the borrower. These payments depend on the length of the borrowing period, the borrower's financial and credit quality, current interest and inflation rates, and the overall strength of the economy.

Major Types of Bond Issuers

There are five major categories of bonds issued by different entities such as the federal government, states, unique public entities, corporations, and non-U.S. sovereign nations. Each has its performance and risk characteristics, pricing factors, denominations, time durations, qualities, and tax benefits.

1. Bonds issued by the federal government

Treasury bonds, bills, and notes are issued by the federal government in various durations and, because they have the highest quality backing, they often pay the lowest interest rate of other bond categories. These bonds are issued in durations ranging from 30 years to one year.

2. Bonds issued by states and municipalities

Municipal bonds are issued by state and local governments and their agencies. The interest paid on these bonds is tax-free so that they can benefit investors depending on their tax bracket and if they are a resident of the state or municipality where the bond is issued. Investors in these securities receive periodic payments similar to other bond coupon payments.

3. Bonds issued by unique public entities

Other U.S. government bonds include those from the Federal National Mortgage Association, the Government National Mortgage Association, and the Federal Home Loan Mortgage Corp. These bonds can deliver higher yields than U.S. Treasuries, but their risk is considered minimal. These bonds are subject to state and federal taxes.

4. Bonds issued by corporations

  • Investment-grade corporate bonds

    This $8.1 trillion market is among the most popular bond categories, and its proceeds are used primarily for financing. These bonds pay the highest interest rate, but they also have the highest possibility of default.

  • High-yield or "junk" bonds

    If a corporation has a weak balance sheet, often with a rating below triple-B, it is considered high-yield. These bonds have a higher probability of default than corporates. As a result, their prices more closely track the company's stock price and its balance sheet.

5. Bonds issued by non-U.S. sovereign nations

Nations issue foreign sovereign bonds outside the U.S. They deliver returns tied to their own national currency. As a result, they are subject to risks associated with the issuing nation's political and fiscal stability and interest and currency fluctuation rates.

Other Bond Varieties and Hybrids

Mortgage-backed bonds

Mortgage-backed bonds are secured by property mortgages and are then bundled into securities that are sold as packages to investors. These bonds will suffer a decline in value as mortgage pre-payments increase. As a result, their price will not rise as much when interest rates increase.

TIPS ETFs

Treasury Inflation-Protected Securities (TIPS) ETFs can protect portfolios against inflation increases since their prices are adjusted systematically to keep pace with inflation. This gives investors more stability in their real returns. This is especially important now as markets question the direction of the nation's long-term deflationary trend and whether it will continue unabated into the future.

Zero-coupon bonds

Zero-coupon bonds are hybrids that have special characteristics. As their name implies, these bonds do not pay periodic interest payments to investors at regular intervals. Instead, they pay the face value of the bond only at maturity. These maturity dates can be 10 to 20 years into the future.

These bonds are issued by the federal and state governments. Municipalities and corporations and can be bought more cheaply than other bonds. Their prices fluctuate more than different types of bonds since interest is only paid at maturity. They are well-suited for funding long-term goals, such as a child's education or a future purchase. Investors can also avoid paying taxes on zero-coupon municipal bonds if they are residents of the state where the bond is issued.

How to Select Bonds

Armed with a clear understanding of the types of bonds available, investors can then choose to buy individual bonds, bond mutual funds, or bond ETFs in an actively managed or passive portfolio.

With so many bond choices, investors have to make the basic decision about how to buy bonds, which investment carries the least amount of risk, and how bonds fit into any asset allocation strategy.

Making these basic decisions requires that an investor know their own risk tolerance and time frame since bonds deliver optimal performance over a longer time frame than equities.

Factoring in inflation

Then there is the critical issue of how inflation affects bond performance. With few exceptions, all bonds are affected to various degrees by inflation, as well as the overall economy.

With rates at a 60-year low, the Fed recently announced it will keep rates low for a more extended period to boost employment opportunities as a result of the COVID crisis. In the near future, this means the Fed will not raise interest rates to guard against coming inflation.

Bond Investing Strategies

So what strategies and types of bonds are available to profit and protect portfolios in a flat interest rate environment? And how can bonds be used to plan for retirement?

The answers lie in understanding some of the basic factors that drive the performance of individual bonds, bond mutual funds, and ETFs in a flat interest rate environment. Then, investors can choose the right instruments and strategies to achieve their goals and see how bonds can complement any asset mix and reduce levels of risk.

Flat yield curve environments

In a flat yield curve environment, the yield spread between short- and long-dated bonds is about the same when they are of equal credit quality. In this situation, investors are not rewarded for holding bonds of longer duration and assuming more risk.

Historically when rates rise, they do not impact all bonds in the same way.

A rate hike of 1%, for instance, will drive down high yield municipal bond rates by 10.7% and 10-Year Treasuries by 8.5% and emerging market debt by 5.2%. In a rising rate environment, other major bond categories and maturities also decreased in price ranging from two-year Treasuries (-2%) to Mortgage-Backed Securities (5.3%.)

In this example, given their negative price moves in a rising rate environment, investor portfolios should include various bonds and durations to dampen volatility, while also taking into account a client's risk tolerance, time frame, and goals.

The strategy that can help achieve this is done by holding bonds in short (less than five years) and long maturities (10 years or longer). For example, this "barbell" strategy divides half the bond exposure to 10-year Treasuries and the remainder to Two-Year Treasury Notes. When rates rise, the bond investor has reduced rate risk because the short-term bonds should be reinvested into new short-term bonds at the higher rates.

The barbell strategy reacts to changes in the interest rate and inflation environment. It is an active strategy but is well-suited to extract returns over time in an uncertain interest rate environment.

Generating Income from Different Sectors

Bond income can be generated by taking credit or interest rate risk, often by extending duration. When rates decline, extending duration may present some attractive income opportunities; but in a rising rate environment, investors lose this advantage.

However, when credit spreads narrow and government bond yields remain low, investors should consider mortgage-backed securities (MBS), especially when bond analysis can find good opportunities in this complex market by focusing on reducing credit risk.

Selecting and monitoring MBS requires complex loan-level mortgage analysis because these bond prices rely on housing market forecasts, as well as loan and default histories. With an MBS ETF, investors can avoid the problems of duration volatility and rate risk while benefitting from an expertly managed, liquid, income-producing investment.

How Bonds are Taxed

There are different tax rates for government, corporate, zero coupons, savings, and municipal bonds. IRS tax form 1099-INT has some general directions for paying taxes on bonds, but this form alone is not complete.

All bonds in the secondary market (when bonds are traded after they have been issued) are subject to pay capital gains or incur losses depending on the bond's price when it was bought or sold. Certain types of bonds, most commonly municipal bonds, offer tax benefits to investors depending on their tax bracket and residence.

Corporate bonds pay taxes on the interest earned, capital gains, and discounts on the issue. Interest earned, typically paid every six months, is taxed at the federal and state levels. Corporates also pay a capital gains tax when the bond is sold.

The income produced by taxable bond funds is commonly taxed as ordinary income the year it was earned at the federal and state level. The interest earned on a savings bonds is subject to federal income tax but not state or local income taxes. For zero-coupon bonds, although the interest is paid only at maturity, investors have to pay taxes on the interest annually based on a "phantom" or calculated rate.

Pros and Cons of Bond Funds and ETFs vs. Individual Bonds

The bond market is so diverse and fluid that it demands a high level of analysis to select the right mix of bonds. Once the individual bonds are chosen, they have to be monitored to determine they are meeting their risk and return objectives. All bond prices fluctuate with interest rate and macroeconomic changes, while corporates reflect the issuer's changing financial outlook.

Unless you are a sophisticated bond analyst, a bond fund or ETF may be the better choice to get the needed fixed income exposure, with low fees and expenses similar to many mutual funds.

The Investment Company Institute lists 390 bond ETFs (as of July 2020) and 2,131 open-end bond mutual funds. Of these mutual funds, 1,578 were taxable, and 553 specialized in municipals.

Investors can choose from international bond ETFs from non-U.S. nations and corporations. This includes bonds from developed or emerging-market issuers. The benefit of ETFs is that investors receive various issuances in a single, low-cost, professionally managed product.

What Is a Robo Advisor and How Do They Work?

Key Bond Terms

Par

This is the face value of the bond and the amount of money (plus interest paid over the borrowing period) returned to the investor when the bond matures.

Coupon interest rate

This is the annual interest rate that the bond issuer agrees to pay the borrower. If an investor buys a $1,000 bond with a 5% coupon, the borrower will get $1,050 at maturity in one year.

Maturity

This is the borrowing period for the bond. When this period ends, the borrower receives the par value of the bond.

Discount

Bonds can trade above or below their par value. When a bond trades below its par value, it is trading at a discount.

Call provision

When an issuer wants to redeem their bonds before the maturity date, they exercise the call provision. Issuers do this when the prevailing interest rate is lower than the rate that was set when the bond was issued.

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