We all live busy lives and only have so much time that can be dedicated to learning about the financial markets and executing our portfolio strategy. With that in mind, I would like to present, as concisely as possible, my outline for obtaining long-term success in bonds. It consists of the following seven steps.
- Buy individual bonds. As far as I’m concerned, giving away part of your yield to a bond fund manager, in the form of an expense ratio, is, in most cases, not a prudent move. This is especially true if the focus of your bond allocation is investment grade bonds (as the focus is for so many investors).
To see a list of high yielding CDs go here.
- Hold bonds to maturity. You may later change your mind about a particular bond and decide to sell it early. But the original intent should be to hold individual bonds to maturity. One exception to the rule is the following: If you find another bond yielding the same or more than a bond you currently own, and the other bond is attractive to you from a credit perspective, there may be an opportunity to book gains in one bond and roll the original principal into another. The goal of this strategy is to capture profits without experiencing a drop in income. Occasionally, it’s even possible to capture profits and increase your portfolio’s income at the same time.
- Ladder your allocation. Creating a bond ladder involves staggering the maturities of the bonds in your portfolio. How the ladder is constructed depends on your personal circumstances and your views of future interest rate moves. While one investors may prefer a bond ladder staggered with 1- to 10-year maturities, another may prefer a ladder with 7- to 30-year maturities.
- Diversify your allocation across many issuers. Just as investors are taught to diversify their equity allocations, so to should investors diversify their bond allocations.
- Focus on yields that have historically provided “real” rates of return. In today’s environment, it is challenging to find what I’ll call “good” bonds, trading with positive after inflation, after tax yields. But such yields are still available today, if you’re willing to extend maturities or work your way into the non-investment grade space.
- Manage your liquidity properly. You know best what your liquidity needs are and are likely to be in the future. Be sure to manage your liquidity in a way that allows you to avoid having to sell your bonds at inopportune times.
- Be mindful of the opportunity cost of trying to time the market. If you sit for long periods of time in securities that provide negative real rates of return, because you think the future path of interest rates is higher, by the time you finally buy those “real” yields so desired, you may discover that it wasn’t worth the wait. After all, if you forgo, say, 5% yields for an extended period of time, because you’re waiting for 6% yields, and, in the meantime, you sit in cash earning near 0%, the eventual 6% yield you capture may never be enough to compensate for missing months or years of 5% interest.
As people begin their investing journeys, they may not have enough capital to properly diversify using individual bonds. While it doesn’t take as much capital as many will have you believe, I recognize that in the beginning, it may not be feasible. In the beginning, however, you are likely at an age at which you have plenty of years ahead of you before retirement. Therefore, at that time, bonds may not be a big focus of yours anyway. Eventually, as your portfolio grows larger, and you shift your portfolio allocation more toward bonds, remember the strategy for success I’ve outlined above.
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