Diversifying Bonds

THE BOND MARKET arguably offers more variety than the stock market—which is why investors often get into more trouble with bonds. We expect stocks to be risky. But we assume bonds are safe, and yet some bonds are almost as risky as stocks. Looking to diversify your bond portfolio? You can slice up the world of bonds in six ways:

By geography. As with stocks, you can divide bonds between U.S., developed foreign and emerging markets. But the case for buying foreign bonds isn’t as compelling. The investment costs can be high, and you could be introducing the wild card of currency swings into what’s supposedly the conservative part of your portfolio.

By maturity. Bonds have maturities of up to 30 years and occasionally longer. But the longer the maturity, the more a bond will fluctuate in price in response to interest-rate changes. Historically, you have earned much of the yield of longer-term bonds by purchasing securities with five years or less to maturity.

By how interest payments are calculated. While most bonds make fixed interest payments, some offer interest payments that “float” with the overall change in interest rates or increase along with inflation.

By whether the interest is taxed. Interest from corporate bonds is fully taxable. Interest from Treasury and some government agency bonds isn’t taxable at the state level. Municipal bonds are exempt from federal taxes and, if you own bonds from your own state, possibly also state and local taxes.

By whether the issuer is part of the public or private sector. Corporate bonds are riskier than government bonds, but offer higher yields.

By the quality of the issuer. While bond investors can usually expect to get both the promised interest payments and their principal back at maturity, that isn’t a sure thing with so-called junk bonds, which are issued by companies with shaky finances. To compensate investors for the greater risk of default, junk bonds offer higher yields.

Sound overwhelming? It’ll seem less baffling if we look at some sample portfolios.

Next: Portfolio: One Fund

Previous: Diversifying Stocks

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