August 29, 2019

How to Build a Bond Portfolio

Since I started this 10th Man bond series, you guys seem to be split broadly into two camps.

On one side, there are people who remain anti-bonds. Or at least, anti-investing-more-in-bonds.

On the other side, there are the “yes, but” folks, who get why it’s important but feel blocked from doing much about it, for different reasons.

Anyway, as I said last week, we’ll be throwing you a lifeline soon. I’m working on something pretty important that is a) going to make bond investing a lot easier and b) be beneficial even if you’re anti-bonds (yes, really).

For now though, let’s continue with an article based on a question I’m getting from lots of you: how would you build a bond portfolio?

Best Practice

The best way to build a bond portfolio is to start by thinking about the risks.

A portfolio of bonds can go down, you know.

Yes, I know that US Treasurys cannot technically default (or at least, they haven’t so far). But they can decline in price, and the decline can be substantial.

For example, if long term interest rates go up a lot—say 2% or so—the price of a 30-year Treasury bond could drop by as much as 40%. That’s a scary number. Most people aren’t worried about that right now. They may be someday.

So we are definitely concerned about the direction of interest rates, known as duration risk. For US Treasury bonds, that is pretty much the only risk.

For other types of bonds, there are other risks. Corporate bonds can and do default. They haven’t in a while, but they will someday. More importantly, the price of these bonds will decline as the market perceives companies to be less credit worthy. In the investment community, this is known as spread widening. The spread between corporate interest rates and Treasury interest rates will widen.

In the last credit meltdown in 2015, led by energy credits, high yield spreads widened to about 700 basis points over Treasurys.

That’s a bunch of gobbledygook to many people. What does that mean to me as an investor in a bond mutual fund?

Well, if you own a high-quality investment grade corporate bond fund, the most it can probably go down because of credit concerns is about 5-7%. If it is a fund that is concentrated in BBB credits, perhaps a bit more.

If you own a high yield bond fund that focuses on BB credits, your downside is probably capped at around 20%. If it owns mostly speculative CCC credits, you could lose 30% or more. This is also true for convertible bond funds.

With international bonds, it is very much dependent on the situation, but emerging market bonds tend to be very economically sensitive and the downside could be large if we have a global recession.

Mortgage-backed securities are pretty boring most of the time, except in 2008, or if interest rates rise rapidly.

One day, municipal bonds will be very, very exciting. Although people have been saying that for 15 years or more.

Now that we know the risks, let’s build a portfolio.

First Things First

What is your income? If it is north of $300K-$400K, you will want to consider owning lots of municipal bonds. Yes, I’ve heard all the arguments against munis—unfunded public pensions leading to muni bond defaults, blah blah blah. Maybe that is an issue in the next recession. Maybe not.

For the rest of the portfolio, you will want a mix of Treasury and corporate bonds. With yields this low, people are tempted to massively overweight corporates. I understand that sentiment.

By the way, one thing that is poorly understood about investment grade corporate bonds is that they are also very sensitive to interest rates. When Apple issued their first bonds back in 2013, people were surprised to see 10% of the value evaporate in a month—all on duration.

High yield bonds have a little exposure to interest rates (especially with the low coupons these days), but not much. Mostly, they are correlated with stocks.

So:

Treasury—all interest rate risk.

Investment grade corporates—some credit risk, some interest rate risk.

High yield corporates—mostly credit risk (they behave like stocks).

I don’t have a rubric here for what you should do, but your instincts on this—to overweight corporates to get more yield—are probably bad. This is actually the wrong time to be reaching for yield.

It’s the right time to be reaching for safety. Had you done so 8 months ago, you would be pretty happy today. Treasury bonds are up over 20% this year.

Maturity Matching

The other thing you need to consider when building a bond portfolio is the length of maturity you want.

Short-term bonds = less interest rate risk and less credit risk.

Long-term bonds = more interest rate risk and more credit risk.

You could just do it naively and pick a range of maturities. I’m not going to talk about it here, but you might want to do some research on bond laddering, the idea of which is to spread your risk along the interest rate curve.

The school of thought is that you want to match your bond maturities with your liabilities.

If you are going to retire in 30 years, you probably want 30 year bonds. If you are going to send a child to college in 10 years, you probably want 10 year bonds.

If you have a view on interest rates, that can help. For example, I think that the Fed is likely to cut rates to zero and beyond. This would make shorter maturities more attractive.

Once you put together your portfolio, you can figure out the weighted average maturity. A typical bond portfolio has a weighted average maturity of 5-7 years. If you are worried about interest rates or credit, you can make it shorter, or vice versa.

More Art Than Science

The key here is diversification. A portfolio full of municipal bonds will expose you to, well, the idiosyncratic risk that muni credit blows up.

And yes, this is more art than science.

And I know it’s not straight-forward. One reader said this recently: “I went into bonds hoping to ease up on time needed on my portfolio, but now I think shares are simpler!”

He’s not wrong.

But the bond market is much larger than the stock market. For many reasons, it is not clever to avoid it altogether.

Jared Dillian

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