As you build your investment portfolio of fixed-income securities, there are various techniques you and your investment advisor can use to help you match your investment goals with your risk tolerance.
No matter what your investment objective, it makes good sense to diversify your portfolio.
Diversification can provide some protection for your portfolio, so if one sector or asset class is in the midst of a downturn, the rising value of another class of assets may help offset the negative impact.
For example, suppose your portfolio held a variety of high-yield and investment-grade bonds.
You chose the high-yield securities for their greater returns. The investment-grade bonds probably generate somewhat lower yields, but their ability to weather economic downturns should offset potential credit-quality concerns which could affect the high-yield securities in the portfolio.
Similarly, you might want to balance corporate issues with U.S. Treasury, municipal or mortgage-backed issues offered by government-sponsored agencies.
Another diversification strategy is to purchase securities of various maturities.
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 securities, the kind least sensitive to changing interest rate risk, you would have a high degree of stability, but you might be giving up yield.
Conversely, investing only in long-term securities may result in greater returns, but their prices will be more volatile, exposing you to losses should you have to sell before maturity.
Building a laddered portfolio involves buying an assortment of bonds with maturities distributed over time. For example, you might invest equal amounts in securities maturing in two, four, six, eight and 10 years.
In two years, when the first bonds mature, you would reinvest the money in a 10-year maturity, maintaining the ladder.
Your return would be higher than if you bought only short-term issues. Your risk would be less than if you bought only long-term issues.
You would be better protected against interest rate changes than with bonds of one maturity.
If interest rates fell, you’d have to reinvest the securities maturing in two years at a lower rate, but you’d have the above-market return from the other issues.
If rates rose, your total portfolio would pay a below-market return, but you could start correcting that in two years or less when your shortest issue matured.
This strategy also involves investing in securities of more than one maturity to limit your risk against fluctuating prices.
But instead of dividing your money in a series of bonds distributed over time, as with a laddered portfolio, you’d concentrate your holdings in bonds with maturities at both ends of the spectrum, long — and short-term — for example, bills or notes maturing in six months or a year, and 20 or 30-year bonds.
Investors use bond swaps to realize a variety of benefits. A swap, the simultaneous sale of one security and the purchase of another, may be done to change maturities, upgrade the credit quality of the portfolio, increase current income or achieve a number of other objectives.
The most common swap is done to achieve tax savings. Anyone owning bonds selling below their purchase price and having capital gains or other income which could be partially, or fully, offset by a tax loss can benefit from a tax swap.
In a two-step process, the investor would sell a bond that is worth less than what he paid for it and would simultaneously purchase a similar bond at approximately the same price.
By swapping the securities, the investor has converted the paper loss to an actual loss which can be used to offset capital gains of ordinary income each year on a joint return.