Bond Diversification - How It Can Help Control Your Portfolio Risk

Generating high yields with limited risk seems to only get more and more difficult for long-term investors. Traditionally US Treasury Bonds have served as the core of a conservative portfolio. Potential inflation, rising interest rates, and political turmoil make the current environment treacherous for what used to seem like safe haven investments.

Assembling a blend of fixed income assets that includes TIPS and international bonds - along with US Treasury Bonds - can make a portfolio more efficient – increasing yield while at the same time reducing risk. Below we discuss why and how to diversify your bond portfolio to achieve risk-controlled performance in a potentially difficult environment.

Diversity Benefit of US Bonds, TIPS, and International Bonds
The global nature of the international financial crisis in 2008 heightened the sense that individual markets are following a single, globalized business cycle. But regional macroeconomic fundamentals frequently dominate yield changes.The chart below shows returns over the past seven years of US Bonds (the Barclays US Aggregate Bond Index), International Bonds (the S&P/Citigroup Intl. Treasury Bond Index) and TIPS (the Barclays Capital US TIPS Index):

As you can see above, Barclay’s US aggregate bonds, unhedged global bonds and TIPs have performed quite differently in recent years. The TIPS return is a function of US inflation expectations and real US interest rates, whereas unhedged global bond returns are driven by foreign interest rates and exchange rate fluctuations (if the US. currency falls in relation to the currency paid on the foreign bond, the bond investor will gain as the foreign currency will convert into a greater amount of US dollars). Looking ahead, if the entire world experiences uniform inflation, TIPs would be the better choice for defensive investors, but in the case that US inflation is higher than the global average, global bonds will likely perform better. So a combination of both asset classes are good to hold in your portfolio, with the precise mix determined by the your risk-aversion level.

How to invest in international bonds?
There are numerous historical examples of sovereign nations defaulting on their sovereign debt or severely devaluing it. Conservative investors are best to consider broadly diversified international bond funds. iShares S&P/Citi International Treasury Bond (IGOV) and SPDR Barclays Capital International Treasury Bond (BWX) are examples of ETFs that target the performance of fixed-rate, local currency, sovereign debt regions in regions outside the US. These are indexed funds weighted by global, investment grade, sovereign debt balances.

 

TIPS Yield
TIPS may not appear appealing at first glance, now –the yield on the Vanguard Inflation Protected Securities (VIPSX) is at 2.44%, but as noted in by Larry Swedroe in hisTIPS Update for March 2011, current Treasury Yields are only slightly higher than TIPS yields, so with exposure to TIPS you’re getting inflation insurance while “paying” very little insurance premium.

 

Bond Duration
Finally, one basic necessity to control risk in your Bond Portfolio is to manage the duration of your bonds. Investors who have pushed out further on the yield curve by investing in longer-term bonds will see a greater decline in the principal value of their investments if interest rates continue to rise. In our September 28 Portfolio Research Analysis we discussed how duration is a useful measure of the sensitivity of a bond's market price to interest rates.

 

Achieving Higher Returns with less risk
Many risk-averse investors are abandoning fixed income assets altogether - since December 2011, US investors have yanked over $18 billion from their fixed-income portfolios. Even after this shift, a high percentage of household fixed income allocation remains in long-term treasury bonds. But now, as much as ever, we argue that: (1) bonds are always part of a diversified portfolio, (2) international bonds and TIPS should be part of that bond allocation, (3) the potential risk of inflation makes diversification particularly important now, (4) diversification across different types of bonds can produce a portfolio with lower volatility.