Should I diversify the types of Bond ETFs I want to buy?

When buying bond ETFs, should I diversify the types of bonds, or can I buy three of strong performing corporate bond ETFs, such as the ones recommended in your article?

Bonds / Fixed Income, ETFs
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January 2017
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You should always attempt to diversify somewhat. If your question is 3 strong performing corporate bond ETFs within the same sector i.e. investment grade bonds, then I would look at the top 10 holdings in each ETF to see how much overlap there is. You might be surprised. Another thing you can do is to compare the correlation between the ETFs. This can be done easily on a chart. But if they are very correlated, you may not be getting the diversification you think you are by owning 3. Thus, they may have all done well at the same time, but will also do poorly at the same time and go down together.

A more important factor is the direction of interest rates. If you believe interest rates are on the rise, then you need to shorten your maturity and duration (not quite the same thing). I personally am not going to own any L-T bonds at the moment unless it is for a shorter term trade rather than an investment. I would focus on investment grade mid-term bonds (5-7 years) and wouldn't go out much further. This is because I believe the long term dropping interest rate cycle is over, and thus, the long term bull market in bonds may be coming to an end. In fact, depending upon the sector and more importantly duration, bonds have lost anywhere from 3% to 7% in value since peaking last year in the early fall.

And if interest rates do rise, it will hurt the real estate market. So, I think you are in the right sector, but need to make sure you are also picking the right maturity. Don't get lured into the higher interest of longer term bonds because they will also have higher losses if rates rise.

Now the opposite would be true when rates are dropping. When rates are likely to drop, that is when you would want longer term bonds for the higher interest and higher capital gains. This is my personal opinion and I just feel that the bond market carries more risk than it did just a year ago. So, the very first question you must ask yourself is which direction do you think rates are headed? Then, what effect will it have on the various sectors?

I hope this gives you some perspective for your research. Best of Luck, Dan Stewart CFA®

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