Equity markets often attract more attention than fixed-income investments since they are perceived as a bit more exciting, but investors aiming for a well-diversified portfolio know better than to overlook the latter. While returns from fixed-income investments may not be exciting, bonds can play a crucial role in smoothing portfolio returns when volatility picks up.
Maintaining a fixed-income allocation to reduce portfolio risk is just the first step. The next is adjusting fixed-income exposure in response to changing market conditions.
Bonds Are Crucial to Any Portfolio
Savvy investors have an active strategy with regard to fixed income, knowing when to buy and sell, and also how to value bonds through credit spreads, currency fluctuations and yield curves. In all cases, several concepts should be used as a basic guideline to the mechanics that affect fixed-income prices.
Here is an example with interest rates: If you buy a $1,000 bond with a fixed coupon rate of 3% and a 10-year maturity, every year you get $30 in interest, and in 10 years the issuer will give you the $1,000 back. When interest rates move, such as if the company issues a new $1,000 bond with a 4% coupon, the price of your 3% will drop to balance out the difference, and vice versa.
Not all bonds have the same sensitivity to interest rate fluctuations, though. Longer duration bonds are more sensitive to risk and thus tend to have higher yields. If interest rates are expected to rise, investors should own shorter duration bonds, as those will decline less in price than longer duration bonds will if rates increase. (For related reading, see: The Basics of Bond Duration.)
Know the Risks of Your Bond Issuer
Another factor to consider when allocating the fixed-income portion of your portfolio is the bond issuer. More specifically, understand the potential for a company’s financial health to deteriorate to the point that it cannot repay the principal or files for bankruptcy. Credit rating agencies may be helpful here, as they rate bonds as investment grade versus high-yield and also issue downgrades, which may signify increasing risk.
The difference between the yield on a risky bond and the yield of a risk-free bond (like one issued by the U.S. government) is called a credit spread. When the economy is strong and growing, credit spreads narrow. On the flip side, in times of economic distress, credit spreads widen. This makes sense because there is a higher probability that debt-laden issuers will default.
Bond Buying in a Down Market
Much like a recession can be a good time to bottom-fish beaten-down stocks, recessions are also a good time to buy high-yield bonds. Buying junk bonds during the Great Recession may have seemed risky at the time, but it was extremely profitable for those with a good understanding of the fixed-income market. Determining which bonds are less risky than their yields suggest is the key determination here.
Currency risk is another factor to consider, especially if you’re looking at bonds outside the United States. Let’s say you have $10,000 and use it to buy a German bond yielding 5%. To do so, you first have to exchange that money for Euros, then when the bond is mature, you’ll have to change it back. (For related reading, see: How Currency Risk Affect Foreign Bonds.)
The exchange rate between U.S. dollars (USD) and Euros, thus, will greatly affect your return. That 5% appreciation in Euros could be a 10% decline in USD or 20% increase in USD, depending on what direction the dollar moves. A U.S. investor buying bonds in foreign currencies should always consider how exchange rates are expected to move over the course of the bond’s life.
Steady Hands During Volatility
Thanks to tax cuts, a more aggressive Federal Reserve and strong economic growth that has increased interest rates, fixed-income investments are on pace for one of their worst years over the last two decades.
Some investors may be tempted to shrug off bonds altogether, as the supposedly “safe” part of their portfolio declines in value. But bonds are crucial for adding value to a portfolio, especially during volatile times like this. Just like not all stocks have the same expected return, bonds also have varying risk profiles. Understanding the functionality of bonds is paramount for balancing your portfolio, whether that means weathering a storm or adding additional upside. Risk awareness, high yield potential and taking advantage of profitable exchange rates are all proven methods to actively bolster your fixed-income investments.
(For more from this author, see: Diversify Your Portfolio With Exchange-Traded Funds.)