Bond investors who opt to look at single issues as opposed to pooled products like ETFs, CEFs, and open-ended bond funds, have a variety of choices to make: how much credit risk to take, what kind of blended duration to employ, and yes, how many total bonds to carry in the portfolio. While fund managers are paid to make those decisions, the do-it-yourself, individual investor needs to take charge of matters on their own.
I would argue that there is certainly no defined, optimal number of bonds to carry. Some may be able to build a bond portfolio with a limited number of issues, while others, for a variety of reasons, may own a significant number of bonds. While bond diversification may be viewed in a similar context and alongside a stock portfolio, the thought process behind how and to what extent to diversify will be different, given the nuances of bond versus stock risk.
The following factors may be prime contributors to the thought behind how many bonds are held in a portfolio:
- Total assets – and what portion of a portfolio is invested in bonds.
- Amount of credit risk the investor is taking.
- The general risk tolerance of the investor.
- Amount of time the investor has to manage the portfolio.
- Goals that the bond portfolio is being managed to reach.
In general, I would opine that greater diversity and an increased number of holdings may be prudent in bond portfolios with elevated assets, heightened credit risk, general risk sensitivity, and greater time allocation to managing the portfolio. If the portfolio is being managed to generate ongoing total return as opposed to generate income or preserve capital, then a limited number of holdings may be more prudent.
Taken as a whole, one can start to grasp how many bonds would serve them well. For investors with limited funds or who limit their allocation to bonds, there might be need for only a few pieces of paper. Investors with high net worths, those taking more risk, or those that are totally risk averse may own an inordinate number of issues. And though continued diversification may make sense, if ongoing management of the portfolio becomes problematic for whatever reason, then curbs should be set.
Some are some common rules of thumb for stock investors – total stock allocation should be 100 minus your age and that you should never have more than 5% of total assets in one stock – i.e. own at least 20 stocks. Since the risks involved in individual bond investing are arguably much less pronounced than stocks, portfolio concentration is generally frowned upon much less as well.
So a high net worth individual could theoretically invest all of their money in a AAA corporate bond and think that their risk is very low, and theoretically they’re right.
However, one black swan (unanticipated) event that strikes that company could destroy one’s portfolio. Thus spreading the risk even amongst security types that are viewed as low-risk, or even no-risk, is a wise move. In the end, especially for risk intolerant investors, you should continue to add bonds to a portfolio to mitigate black swan events and get yourself to a point where you can sleep well at night.
In a day and age where the stock market hovers at all time highs and high-yield bond defaults are minimal, I think investors are prone to being much braver than they really should be. While I’m certainly not predicting financial doom going forward, a portfolio should never be managed with rose-colored glasses.
While there’s no set answer to how many bonds one should own, the question can be answered introspectively by evaluating personal risk tolerance, coupling that baseline with specific bond investing goals and the types of specific securities that will be invested in to reach those goals.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.