Bonds serve an important role in the portfolios of many individuals and organizations as they provide income, liquidity, and help reduce portfolio volatility.
If your financial plan warrants investing in bonds, what type of bonds should be in your portfolio?
At Foster Group we focus on two primary characteristics of fixed income investments to help us answer this question – maturity and credit quality.
As a bond holder, essentially you are providing a loan to a corporation or government. The maturity is how long the loan lasts. If you purchase a corporate bond that matures in eight years, you will receive interest payments for eight years and then the return of your principal (the initial dollar amount invested) at the end of the eight years.
We focus on maturity for two primary reasons:
- Longer maturity bonds have higher expected returns than bonds of similar credit quality but shorter maturities, to compensate investors for locking up their money for longer periods.
- Market prices of longer maturity bonds are more sensitive to changes in interest rates (more volatile) than shorter maturity bonds.
Short-term (e.g. 1-2 years) cash needs are best met with short-term bonds, because of their lower volatility. Intermediate-term needs (three years and beyond) are best met with longer, intermediate-term bonds, because of their higher expected returns.
The other primary characteristic we focus on is credit quality. The credit quality of a bond is related to a company’s financial condition. Companies that aren’t doing well financially will have a lower credit rating, because they have a higher chance of default.
Alternatively, U.S. Government bonds are said to have no credit risk, because they are backed by the full faith and credit of the U.S. Government. Viewed by many financial advisors as a “safe haven,” intermediate to longer term U.S. Government bonds are one of the few asset classes that tend to increase in price when stock markets drop. That helps reduce portfolio volatility in times of stock market stress. Keep in mind that even U.S. Government bonds may be worth less if they need to be sold before their maturity date.
Credit quality is an important consideration for these reasons:
- Maintaining the stability of the bond portion of the portfolio for liquidity needs
- Reducing overall portfolio volatility
Fixed Income Investments
At Foster Group, we believe the primary roles of fixed income investments should be to dampen portfolio volatility and provide liquidity. We focus on higher quality bonds and have a dedicated sleeve of short maturity, fixed income to meet near-term cash needs. Investors could attempt to achieve potentially higher returns by investing in non-investment grade, high yield or “junk” bonds. However, historically, stock markets have done a much better job at growing wealth over time than bonds. Therefore, equities are the primary growth engine in our portfolios.
To ensure our clients are not overexposed to any one issuer, we follow the principle of diversification with our bond portfolio. We diversify across the globe in many different countries, issuers, sectors, maturities, and credit ratings, using low cost mutual funds and exchange traded funds.
Remember, bonds serve an important role in the portfolios of most individuals and organizations as they provide income, liquidity, and reduce portfolio volatility. When deciding what bonds to invest in, consider maturity and credit quality. And remember, your financial plan should determine your need for fixed income.
PLEASE NOTE LIMITATIONS: Please see Important Disclosure Information and the limitations of any ranking/recognitions, at www.fostergrp.com/info-disclosure/. A copy of our current written disclosure statement as set forth on Part 2A of Form ADV is available at www.adviserinfo.sec.gov.