Most investors seem to fall into two camps when it comes to bonds.
On one side, there are people who remain anti-bonds. Or at least, anti-investing-more-in-bonds.On the other side, there are the “yes, but” folks. They get why it’s important but don’t take action because they don’t know where to start.If you are in the latter camp, let me tell you how you should build a bond portfolio.
Know Your Risks
The best way to build a bond portfolio is to start by thinking about the risks.A portfolio of bonds can go down, you know.Yes, I know that US Treasuries cannot technically default (or at least, they haven’t so far). But their price can go down, and substantially.For example, if long-term interest rates go up a lot—say 2% or so—the price of a 30-year Treasury bond could drop by as much as 40%. That’s a scary number.Most people aren’t worried about that right now. They may be someday.So the first consideration is the direction of interest rates, known as duration risk. For US Treasury bonds, that is pretty much the only risk.For other types of bonds, there are other risks.Corporate bonds can and do default. They haven’t in a while, but they will someday. More important, the price of these bonds will decline as the market perceives companies to be less credit worthy.This is known as spread widening. The spread between corporate interest rates and Treasury interest rates will widen.In the last credit meltdown in 2015, led by energy credits, high-yield spreads widened to about 700 basis points over Treasuries.That’s a bunch of gobbledygook to many people. What does that mean to me as an investor in a bond mutual fund?Well, if you own a high-quality, investment-grade corporate bond fund, the most it can probably go down because of credit concerns is about 5–7%. If it is a fund that is concentrated in BBB credits, perhaps a bit more.If you own a high-yield bond fund that focuses on BBB credits, your downside is probably capped at around 20%. If it owns mostly speculative CCC credits, you could lose 30% or more. This is also true for convertible bond funds.With international bonds, it is very much dependent on the situation, but emerging market bonds tend to be very economically sensitive and the downside could be large if we have a global recession.Mortgage-backed securities are pretty boring most of the time, except in 2008, or if interest rates rise rapidly.One day, municipal bonds will be very, very exciting. Although people have been saying that for 15 years or more.Now that we know the risks, let’s build a portfolio.
Reach for Safety
What is your income?If it is north of $300K–$400K, you will want to consider owning lots of municipal bonds.Yes, I’ve heard all the arguments against munis—unfunded public pensions leading to muni bond defaults, blah, blah, blah. Maybe that is an issue in the next recession. Maybe not.For the rest of the portfolio, you will want a mix of Treasury and corporate bonds. With yields this low, people are tempted to massively overweight corporates. I understand that sentiment.By the way, one thing that is poorly understood about investment-grade corporate bonds is that they are also very sensitive to interest rates
.When Apple issued their first bonds back in 2013, people were surprised to see 10% of the value evaporate in a month—all on duration.High-yield bonds have a little exposure to interest rates (especially with the low coupons these days), but not much. Mostly, they are correlated with stocks.So:Treasury—all interest rate risk.Investment-grade corporates—some credit risk, some interest rate risk.High-yield corporates—mostly credit risk (they behave like stocks).I don’t have a rubric here for what you should do, but your instincts on this—to overweight corporates to get more yield—are probably bad. This is actually the wrong time to be reaching for yield.It’s the right time to be reaching for safety. Had you done so eight months ago, you would be pretty happy today. Treasury bonds are up over 20% this year.
The other thing you need to consider when building a bond portfolio is the length of maturity you want.Short-term bonds = less interest rate risk and less credit risk.Long-term bonds = more interest rate risk and more credit risk.You could just do it naively and pick a range of maturities. I’m not going to talk about it here, but you might want to do some research on bond laddering. The idea is to spread your risk along the interest rate curve.The school of thought is that you want to match your bond maturities with your liabilities. If you are going to retire in 30 years
, you probably want 30-year bonds. If you are going to send a child to college in 10 years, you probably want 10-year bonds.If you have a view on interest rates, that can help. For example, I think that the Fed is likely to cut rates to zero and beyond. This would make shorter maturities more attractive.Once you put together your portfolio, you can figure out the weighted average maturity. A typical bond portfolio has a weighted average maturity of 5–7 years. If you are worried about interest rates or credit, you can make it shorter, or vice versa.
More Art than Science The key here is diversification
.A portfolio full of municipal bonds will expose you to, well, the idiosyncratic risk that muni credit blows up.And yes, this is more art than science.And I know it’s not straightforward. One of my readers said this recently: “I went into bonds hoping to ease up on time needed on my portfolio, but now I think shares are simpler!” He’s not wrong.
But the bond market is much larger than the stock market. For many reasons, it is not clever to avoid it altogether.
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Related: How to Build a Bond Portfolio That Works