Friday 17 July 2015 by Craig Swanger Education (basics)

Constructing a diversified bond portfolio

The key objective of many bond investors is to build a portfolio of bonds that produces the income they need while minimising risk. Naturally, the details of how to achieve this will depend upon your individual needs and objectives but it is possible to start with a generic framework and then tailor it to suit

rock pile on beach

A good starting point would be to include in your portfolio holdings of fixed, floating and inflation-linked bonds. Each of these serves a specific purpose:

  • Fixed - reduces income risk by locking in future cashflows (coupon payments)
  • Floating - reduces the risk that sudden interest rates rises will reduce the value of your fixed rate holdings and hence, your overall portfolio
  • Inflation linked - reduces the risk of inflation weakening the spending power of your portfolio income

No matter what the current economic conditions are, there is always a risk of conditions changing suddenly. For example, today’s investor could be easily forgiven for assuming that inflation is under control and unlikely to suddenly jump. An investor in 1970 could have been forgiven for feeling the same way as, in the 20 years prior, inflation had averaged 2% to 3% p.a. But in the 1970s inflation spiked to more than 15% p.a., reducing real wealth by half in just five years. 

inflation peaks

So, regardless of the current situation and outlook, regardless of the experts’ views and regardless of the recent stable inflation figures, investors should always have a plan that includes protection against the unexpected future. A defensive approach means that you hold all three types of bonds but adjust the relative proportions according to where you expect our economy to go. 

The diagram below acts as a suggested framework tool for investors to build an investment portfolio that matches their future expectations and provides protection in the event that the unexpected occurs.  For example, you may expect rates to rise so you invest accordingly but rates are then cut instead. An allocation to fixed rate bonds would provide some protection if this scenario unfolded.

Building a defensive portfolio, tailored to your economic expectations
portfolio construction tool

How to use this chart:

1. This is all about the risk/future. That is do you think it is more likely that the economy will strengthen or weaken?

2. Percentage weightings are the target weights, but only if that category offers good relative value.

3. Realistic targets should therefore be plus or minus 10% around these allocations.  For example, if the target allocation is 40%, investors should aim for 40% but settle for 30% to 50% depending on availability.

4. FRNs and inflation linked bonds have similar hedging qualities, so can be substitutes if good value isn’t available at the time. For example. in the low inflation risk/ strengthening economy scenario, 40% fixed and 60% in some combination of FRNs and inflation-linked bonds is better than increasing the 40% allocation to fixed.

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