Investment Strategy Considerations
As you create your investment portfolio of bonds, there are various techniques you and your investment advisor can use to help you match your investment goals with your risk tolerance.
Active vs. Passive
One important consideration is how a portfolio is managed day to day. A portfolio can be actively managed, which means the composition of the portfolio and how often it is traded depend, largely, on the investment decisions made
by you or your investment manager. A passively managed portfolio tends to invest in a basket of stocks or bonds (usually mimicking an index) and, generally, employs a buy and hold strategy, where purchases are made for the long term.
Diversification is the allocation of assets to several categories in order to spread, and therefore possibly mitigate, risk. Regardless of your investment objectives, diversification is an important consideration in building any portfolio. Diversification can be achieved in any number of ways, including by:
Diversification by bond type may provide some protection for a portfolio, so if one sector or asset class experiences a downturn, the performance of other parts of the portfolio may help offset the negative impact. For example, a bond portfolio might consist of a variety of high-yield and investment-grade bonds in order to balance risk and return.
Another diversification strategy is to purchase securities of various maturities in a technique called laddering. When you buy bonds with a range of maturities, a technique called laddering, you are reducing your portfolio’s sensitivity to interest rate risk. If, for example, you invested only in short-term bonds, which are the least sensitive to changing interest rates, you would have a high degree of stability but low returns. Conversely, investing only in long-term bonds may result in greater returns, but prices will be more volatile, exposing you to potential losses. Assuming a normal yield curve, laddering allows returns that would be higher than if you bought only short-term issues, but with less risk than if you bought only long-term issues. In addition, you would be better protected against interest rate changes than with bonds of one maturity.
For example, you might invest equal amounts in bonds maturing in 2, 4, 6, 8 and ten years. In two years, when the first bonds mature, you would reinvest the money in a 10-year maturity, maintaining the ladder.
Barbells are a bond investment strategy similar to laddering, except that purchases are concentrated in the short-term and long-term maturities. This allows the investor to capture high yields from longer maturities in one portion of their portfolio, while using the lower maturities to minimize risk.
Bond swapping is the sale of a block of bond swaps and the purchase of another block of similar market value. Swaps may be made to achieve many goals, including establishing a tax loss, upgrading credit quality, extending or shortening maturity, etc. The most common swap is done to achieve tax savings by converting a paper loss into an actual loss that could partially or fully offset other capital gains or income. We strongly recommend that you speak with your financial advisor to learn more about this investment strategy.