As the saying goes, do not place all your eggs in one basket. This is perhaps one of the most important lessons when discussing investment management and retirement planning. Before we dive into the various diversification options, if you need a refresher on diversification in general, please reference our post from last month. (This post will solely cover diversifying bond or fixed income positions. Last month we discussed stocks and next month will be regarding miscellaneous investments).
We do feel the need to address the concern of overdiversification. Having your investments spread too thin will severely hinder the potential for substantial growth. It is important to focus on the companies and areas that will outperform and decrease exposure to those that are expected to underperform. As Warren Buffet once said, “Wide diversification is only required when investors do not understand what they are doing.”
The issuer of a bond is the source of the bonds itself. The two main issuers we will be discussing today are corporations and governments. Companies issue bonds as a form of debt, which is an alternative cash funding option compared to selling stock. Governments also issue bonds as a form of a debt as an alternative to taxation. The issuer is the source of the debt and they typically make the debt payments to the bondholders or the investor.
The interest rate associated with a bond is primarily based off of the underlying risk associated with the issuer. If the underlying company goes bankrupt, you may only receive a portion of the bond value, if anything. The riskier the issuer, the higher the interest rate. Investors are paid more for buying the debt of riskier companies. Ultra-risky companies are often referred to as Junk Bonds. Those with higher credit ratings are considered Investment Grade. The difference between these two is mainly the fact that Investment Grade companies are less likely to go bankrupt, so they issue debt with a lower interest rate.
Governments are typically more reliable, so treasury bonds typically carry a lower interest rate. However, the strength of the United States is much more dependable than any American company. Foreign companies, especially those that are smaller, often issue debt at higher interest rates. As interest rates continue to fall, this is normally a sign of a healthy economy. In recent years, many countries are issuing debt at near or below zero percent. This is due to the fact that the underlying government does not have the cash flow to pay their debt obligations.
Next up we will discuss the various maturity options for bonds. Maturity essentially refers to the duration of the debt obligation. There are short-term bonds, intermediate-term bonds, and long-term bond options. Like we mentioned above, interest rates increase with a higher level of risk. Purchasing debt for 30 years is much more risky than purchasing debt for 3 years. There are a lot more unknowns and a lot more risk possibilities than can occur over 30 years than can occur in 3 years.
In summary, there are two primary ways that an investor can diversify their bond holdings. The first is a blend of corporate and government bonds and the second includes a blend of varying maturities. The goal through this diversification is to potentially reduce risk within your bond holdings while also aiming to maintain a sufficient level of yield.
If you have any questions about taxes, your individual investment portfolio, our 401(k) recommendation service, or anything else in general, please give our office a call at (586) 226-2100. Please feel free to forward this commentary to a friend, family member, or co-worker. If you have had any changes to your income, job, family, health insurance, risk tolerance, or your overall financial situation, please give us a call so we can discuss it.
We hope you learned something today. If you have any feedback or suggestions, we would love to hear them!
Zachary A. Bachner, CFP®
Robert L. Wink
Kenneth R. Wink
James D. Wink
Summit Financial Consulting