Bonds often raise more questions than answers.
Many people think of investing as only investing in the stock market. The bond market is not often discussed and can be somewhat of an enigma to many. Individual bonds or bond funds? Corporates or muni’s? High credit quality or high yield? Bonds often raise more questions than answers.
In our mind, the purpose of the bond portion of a portfolio is to provide some sense of safety and a ready source of income in times when taking profits from your stocks may not be advantageous. Because the bonds in a bond ladder mature frequently, they also provide liquidity to invest in stocks when stock prices are relatively low. The depth and breadth of the structure of a bond portfolio is of utmost importance and one that deserves further explanation.
Generally speaking, we build a five year bond ladder for most of our clients. Five years typically allows a modest average return, without committing your money for too long of a time, and avoids chasing rates and trying to figure out who offers the best one whenever a bond or CD matures. We purchase individual bonds that mature every three to six months over that five year maturity cycle. Our intent is to hold the bonds until maturity, so interest rate risk is not a big concern for us. In addition to the maturity of the bond, we also pay close attention to the credit quality of the bond issuer. We purchase A rated or better bonds and during the life of the bond, the credit quality and bond price is monitored weekly, making sure the price stays above $90 and the credit quality does not fall below investment grade. That means Baa for Moody’s and BBB- for Standard and Poor’s. Safety is a high priority in our bond portfolios.
Diversification is just as important in the bond allocation as it is in stocks. Our goal is to have no more than 50% of the bond portfolio in corporate bonds. The remaining portfolio consists of FDIC insured certificates of deposit, municipal bonds, and government bonds. Within the corporate bonds we further diversify in various sectors that include financials, utilities, telephone, industrial, and transportation sectors. Within the municipal market we are looking for general obligation bonds and revenue bonds across a wide variety of sectors that include housing, education, industrial development, public service, healthcare, recreation, transportation, and utilities. We believe that the quantity of the bond should be limited, so that it does not represent more than 5% of the portfolio.
For people in search of less volatility and secondarily, income, a bond ladder is an important component of a well-developed portfolio. Because bond funds do not offer any guarantees of interest rate or maturity, in our opinion, they cannot be considered as a safer alternative to stocks.