Risk management should be a primary goal of any investment portfolio. By diversifying a portfolio through the use of stocks, bonds, cash, real estate and other asset classes, investors are able to eliminate a sizable percentage of overall portfolio risk. Investments often move in different directions in various economic and market scenarios, and these patterns can work to an investor's advantage.
For those with an all-stock portfolio, the addition of a bond fund makes the most sense from a risk-management perspective. It still offers the opportunity to earn modest returns while providing significant diversification benefits. There are a number of ways to temper the risk of a stock portfolio using bonds, each of which presents a different risk/return profile.
Total Market Bond Funds
The easiest solution is to add a bond fund that covers all types of securities, including government and corporate issues, across all maturities. Funds such as the iShares Core U.S. Aggregate Bond ETF (NYSEARCA: AGG) and the Vanguard Total Bond Market ETF (NYSEARCA: BND) provide broad bond market exposure across the entire investment-grade spectrum. Both of these examples offer investors a simple all-in-one solution with the added benefit of being exceptionally cheap. These funds both charged less than 0.10% annually, as of May 20, 2016.
Because investors often demonstrate a flight to safety in times of market uncertainty, bond funds tend to increase in demand and value when the stock market is falling. This inverse price relationship benefits shareholders by smoothing out overall portfolio volatility even when either asset class is experiencing significant fluctuation.
Bonds issued by foreign companies and governments provide much of the same risk-reducing benefits as domestic fixed income. The Vanguard Total International Bond ETF (NYSEARCA: BNDX), for example, focuses on the investment-grade bond market of places such as Europe, Asia and smaller emerging-market economies. This fund also comes very cheap, with an expense ratio of 0.15%. However, it came with a relatively below-average yield of 0.68% as of May 20, 2016, due to the fact that the fund typically focuses on lower-yielding government bond issues to help minimize the overall portfolio risk.
Investing internationally carries its own unique set of risks not typically present in the domestic markets. Overseas markets can be affected by geopolitical risks, currency risk and sovereign default risk. In the first five months of 2016, Greece has teetered on the brink of bankruptcy, the strong dollar has acted as a headwind to corporate profits overseas and political tensions surrounding global oil production have sent energy prices fluctuating significantly. All of these additional risk factors have the potential to negatively impact the returns of international securities.
Floating Rate Bonds
Floating rate, or variable rate, bonds provide not only diversification benefits but also help protect against the risk of rising interest rates. Bond prices and interest rates move in opposite directions, making bond funds a relatively poor performer in a rising-rate environment. Funds like the iShares Floating Rate Bond ETF (NYSEARCA: FLOT) invest in bonds with interest rates adjusted according to rate movements in the broader fixed-income market. As interest rates rise, rates on floating rate bonds rise as well. This rate correlation makes price movements of the fund minimal.
The Floating Rate Bond ETF has an effective duration of 0.14. This means for every 1% rise in interest rates, the fund is only expected to drop in value by roughly 0.14%.
Target Maturity Funds
Target maturity bond funds are an interesting option because they have similar characteristics to a certificate of deposit (CD) and a target-date fund. These funds invest in fixed-income securities with maturity dates on or near a specific date in the future. As the fund approaches its designated maturity date, the fund becomes progressively more conservative and securities begin maturing. At its target maturity date, the fund closes and all assets under management are distributed to shareholders.
These funds allow for a laddering strategy, a plan that involves buying securities at several different maturity dates, which is often used with CDs. While the funds themselves lower overall portfolio risk, they also provide additional flexibility and liquidity. Funds invested in longer maturities get the benefit of higher rates, while funds invested in shorter maturities come due quickly, allowing individuals to reinvest in other funds.