Outperforming your average bond fund on a risk-adjusted basis is not a particularly difficult task for the savvy retail investor. For investors, learning how to create a successful bond portfolio starts with learning some simple allocation methods. The advantages of doing so can be immediate, such as avoiding the high management fees some fund managers charge.

It's also important for individual investors to understand that fixed-income fund managers aren't necessarily interested in portfolio optimization, but tend to strive for performance that tracks a respective index. For example, the overall market capitalization of the U.S. fixed-income market is the basis for the popular fixed-income index followed by many fund managers—the Bloomberg Barclays U.S. Aggregate Bond Index, also known as "the Agg."

How can it be so easy to beat Wall Street's best at their game? Let's take a look at how diversifying across the different classes is the basis of successful fixed-income investing, and how the individual investor can use simple bond allocation strategies to gain an advantage over fund managers.

Key Takeaways

  • There are five asset classes for fixed-income investments: 1) government-issued securities, 2) corporate-issued securities, 3) inflation-protected securities (IPS), 4) mortgage-backed securities (MBS), and 5) asset-backed securities (ABS).
  • Each of the fixed-income asset classes comes with investment risks, such as interest rate risk, credit risk, or liquidity risk.
  • Diversification among the fixed-income asset classes is key to building a well-allocated bond portfolio.
  • Building a bond ladder is a strategy fixed-income investors can implement to minimize risks and boost cash flows.

Types of Asset Classes

An enormous amount of innovation continues within the world of fixed income. Fixed income can be broken down into five asset classes:

  • Government-issued securities
  • Corporate-issued securities
  • Inflation-protected securities (IPS)
  • Mortgage-backed securities (MBS)
  • Asset-backed securities (ABS).

For the retail investor, IPS, MBS, and ABS are all relatively new additions. The U.S. leads the world in the range and depth of fixed-income offerings—particularly with MBS and ABS. Other countries are developing their MBS and ABS markets. Government bonds, corporate bonds, IPSs, and MBSs tend to be readily available to retail investors. An ABS is not as liquid and tends to be more of an institutional asset class.

Interest Rate and Credit Risks

The key issue is that each one of these asset classes has different interest rate and credit risks; therefore, these asset classes do not share the same correlation. As a result, combining these different asset classes into a fixed-income portfolio will increase its risk/return profile. All too often investors only consider credit risk or interest rate risk when evaluating a fixed-income offering. In fact, there are other types of risk to consider.

For example, interest rate volatility greatly affects MBS pricing. Investing in different asset classes helps offset these other risks. Asset classes like IPS, MBS, and ABS tend to give you yield pickup without degradation in credit quality—many of these securities come with an AAA credit rating.

Government and Corporate Securities

Many investors are familiar with government and corporate bonds and their correlation during economic cycles. Some investors do not invest in government bonds because of their low yields, choosing corporate bonds instead. But the economic and political environments determine the correlation between government and corporate bonds. Pressure in either of these environments is positive for government bonds. "Flight to quality" is a phrase you will hear frequently in the financial press.

Inflation-Protected Securities (IPS)

Sovereign governments are the largest issuer of these bonds, and they guarantee a real rate of return when held to maturity. In contrast, normal bonds guarantee only a total return. Because inflation can quickly erode the gains investors make on their investments, it's the real rate of return that should be an investor's focus.

Inflation-protected securities are often indexed to the rate of inflation in the issuing country, thus providing investors with protection from the negative effects of rising prices. In the United States, Treasury Inflation-Protected Securities (TIPS) are backed by the U.S. government and are considered a low-risk investment.

Mortgage-Backed Securities (MBS)

When considering the allocation of mortgage-backed securities in your bond portfolio, it's important to understand the risks associated with these securities. In the U.S., institutions such as Fannie Mae and Freddie Mac buy residential mortgages from banks and pool them into mortgage-backed securities for resale to the investment community.

The risks of these securities became clear during the 2007-2008 mortgage meltdown when the MBS market collapsed due to the high default rate of subprime mortgages. When banks and other lending institutions reduce their lending standards, the mortgages that comprise the MBS are riskier, thus placing the MBS investor at a higher risk of loss as well.

Interest Rate Risks

Another risk for the MBS market lies in interest rate fluctuation. Maturity is a moving target with these securities. Depending on what happens to interest rates after issuing the MBS, the maturity of the bond could shorten or lengthen dramatically. This is because the U.S. allows homeowners the ability to refinance their mortgages.

For example, a decline in interest rates encourages many homeowners to refinance their mortgages. Conversely, a rise in interest rates causes homeowners to hold on to their mortgages longer. This will extend the originally estimated maturity dates of MBSs. When purchasing an MBS, investors usually calculate some degree of prepayment into their pricing.

This ability to refinance mortgages in the U.S. creates an embedded option in MBSs, which gives them a much higher yield than other asset classes of equivalent credit risk. This option, however, means MBS prices are highly influenced by interest rate volatility.

Asset-Backed Securities (ABS)

The concept of an asset-backed security is similar to that of an MBS, but ABSs deal with other types of consumer debt, the largest of which are credit cards, student loans, and auto loans. An ABS, however, can be created from almost anything that has material and predictable future cash flows. For example, in the 1990s, royalties from David Bowie's song collection were used to create an ABS.

The big difference between an ABS and an MBS is that an ABS tends to have little or no prepayment risk. The structure of most ABSs is at AAA, the highest credit rating. The liquidity of this asset class tends to be the lowest of the five. Retail investors sometimes have difficulty understanding the ABS, which can make determining the appropriate allocation a challenge when creating a bond portfolio for the first time. However, as we discuss in the next section, there's a simple strategy any investor can use to resolve this problem.

Optimizing Your Bond Portfolio Allocation

When building a fixed-income portfolio, investors should look at diversification the same way as in equity investing—diversification within the asset class is just as important. Equity investors tend to diversify across different sectors (finance, energy, etc.) of the market. Creating a portfolio with material representation from all five fixed-income asset classes we've discussed here is one of the pillars of good fixed-income investing.

Mutual fund managers, however, generally don't adhere to this rule of thumb because they fear they will deviate too far from their respective benchmarks. Savvy retail investors, however, can bypass this weakness and therefore gain an advantage in constructing their own portfolios. It's a matter of carefully combining at least five high-quality bonds with representation from all fixed-income asset classes into a laddered, buy-and-hold portfolio.

Learning how to build a bond ladder is key to boosting returns. Obtaining yield pickup with no loss of credit quality gives an investor the ability to focus on a limited number of bonds. Once again, with a little bit of work, the savvy retail investor can beat Wall Street at its own game.