Why Should You Diversify Your Bonds?

Many investors use bonds to diversify away from stocks. Diversification spreads your risks and wealth-building potential across several assets. 

The desired result: A more profitable, resilient portfolio (hopefully!). 

But you shouldn’t just diversify across asset classes. (That is, stocks vs. bonds.) It’s also important to diversify within an asset class — bonds included. 

Here’s why. 

What does diversifying bonds mean?

Bonds are financial investments that pay interest in exchange for lending money to a company or government. 

Every bond has a maturity date, or the date the lender repays the loan amount (principal). Bonds also set interest rates or “coupons” that the issuer pays until maturity. Investors usually receive bond interest semiannually. They can also pay out monthly, quarterly, or yearly. 

Diversifying bonds involves spreading money into many different bonds. For example, you can diversify your portfolio by buying bonds across:

• Types (government vs. municipal bonds)
• Interest rates (high-rate vs. low-rate) 
• Risk levels (high-credit vs. “junk” bonds)
• Sectors (agriculture, energy, etc.) 

The long-term benefits of a diversified bond portfolio

Owning many kinds of bonds can create a more resilient portfolio. Among other benefits, bond diversification can: 

• Smooth your investment journey. Spreading money around may prevent a market crash from wiping out your whole portfolio. Instead, when part of the market dips, your other holdings can mitigate your losses. 
• Potentially boost returns. Buying many kinds of bonds lets you tap multiple markets and income sources. Plus, bond diversification increases your overall portfolio diversification. The potential outcome: higher long-term returns while possibly lowering risk. 

How to effectively diversify your bonds

Diversifying your portfolio is like putting together a puzzle. To meet your goal, you have to figure out how each piece fits into the whole picture. Here’s how to start “puzzling” together bond diversification. 

Assessing your risk tolerance

The first step to diversification is identifying your risk tolerance. Your risk tolerance describes how much volatility or loss you can withstand. Your unique tolerance depends on your goals, financial situation, and response to risk. 

It’s also smart to align your bond choices with your goals to keep your finances on track. 

Create a balanced bond portfolio

Different bonds respond differently to changes in interest rates or economic circumstances. They also pay different interest rates depending on their type and credit rating. 

To create a balanced portfolio, start by mixing short- and long-term maturities and credit ratings. Mixing these factors lets you seek your ideal blend of growth, return, and risk.  

Diversifying across sectors and industries

Investing across sectors spreads your money into different parts of the economy. For instance, you might buy healthcare, agricultural, and energy bonds. Then, if the energy sector dips, the rest of your bonds will (hopefully) buoy your portfolio’s value. 

Types of bonds to boost your investment mix

Diversifying bonds goes beyond mixing maturities, credit ratings, and industries. You should also look at how different types of bonds could suit your needs. 

Government bonds: the safe(r) bet explained

Government bonds tend to be more stable than corporate bonds. That’s especially true of U.S. Treasury bonds, which are backed by the U.S. government and considered one of the safest investments worldwide. 

Due to their lower risk, they don’t pay as well, but they can make secure short- and long-term investments. 

Corporate bonds: balancing risk and reward

Corporations issue corporate bonds to pay for new projects or existing operations. 

They come in two flavors: 

• Investment-grade bonds. These bonds are highly rated by major agencies like Moody’s and Standard & Poor’s. Higher-rate bonds typically carry less credit risk. (Though they’re not immune to defaults.) 
• High-yield bonds, or “junk” bonds. These have lower credit ratings. In general, they’re more likely to default on their debts. They may also offset this risk with higher interest payments. 

Both types of bonds can have a place in a well-balanced portfolio. It just depends on your goals, needs, and risk tolerance. 

Municipal bonds: invest in your community and save on taxes

States, counties, and cities issue municipal bonds or “munis” to fund new or existing projects. They come in two basic types:

• General obligation munis pay interest from local tax revenue.
• Revenue bonds pay interest from revenue-generating operations like public utilities or toll roads.

Of these two, revenue bonds can face lower default risks. In either case, muni returns are typically exempt from federal taxes. Some also exempt investors from state or local taxes. 

Mortgage-backed securities: unlocking another layer of diversification

Mortgage-backed securities (MBSs) are created when mortgage lenders (or mortgage investors) “pool” mortgages together. The combined mortgages are then turned into a “debt security” that investors can buy. The MBS collects mortgage payments and uses the money to make interest and principal payments. 

While MBSs can offer substantial yields, they carry downsides. For one, inconsistent mortgage payments can create irregular cash flows for investors. Homeowners may also pay their mortgages off early, impacting investors’ returns. 

International bonds: expanding beyond domestic markets

Non-U.S. governments also issue bonds. How “safe” each bond is depends on the issuing country’s creditworthiness, politics, and economy. Bonds issued by the United Kingdom, for instance, tend to be relatively safe. Meanwhile, emerging market bonds may be riskier. 

Global diversification exposes you to the benefits (and risks) of other countries’ markets. If the U.S. enters a recession, the U.K. bond market could prop up part of your portfolio. However, you’ll want to consider the risk that fluctuating currency values could impact your investments. (AKA, currency risk.) 

Avoid these common mistakes when diversifying bonds

There’s more than one way to achieve your investment goals. Unfortunately, there’s more than one way to MISS them, too. When it comes to bonds, many investors stumble into the following (often avoidable!) pitfalls. 

Chasing high yields without considering risk

Higher bond yields may sound great, but they usually come with higher volatility. Before adding those high-interest bonds to your portfolio, take some time to explore potential risks like loss of your principal or interest payments.   

Neglecting to monitor credit ratings

Major agencies like Moody’s and Standard & Poor’s rate bond instruments. The rating represents the agency’s opinion of the bond’s stability and ability to pay its debt. 

While higher credit ratings can indicate a less risky asset, low-rated bonds have a greater risk of default. As with yields, it’s important to explore the risks and benefits before adding low-rated bonds to your portfolio. 

Ignoring the impact of inflation

Most bond investments make fixed interest payments until maturity. Their principal also usually depends on the bond’s original purchase price. Inflation risk poses a risk that as prices rise, the interest and principal on your bonds lose purchasing power. 

TIPS, or Treasury Inflation Protected Securities, offer a workaround. These government bonds adjust their interest rates to account for inflation. 

Overlooking fees and expenses

You probably think about stocks having fees — but what about bonds? Some brokers and investment accounts charge fees to add bonds to your portfolio. (Exact fees and amounts depend on the bond(s), broker, and trade details.) Including these costs in your budget and cost basis gives you a better idea of your long-term return potential.  

Not rebalancing your portfolio regularly

As with stocks, it’s important to rebalance your portfolio regularly to stay on track. You can’t just “set and forget” your bond portfolio. Check in occasionally to keep your assets and goals aligned.   

When and how to rebalance your bond portfolio

It’s unwise to simply “set and forget” any financial account. Make a point to check in regularly to see what (if any) changes could better suit your goals and needs. 

Signs it’s time to rebalance

Rebalancing your portfolio keeps your assets and goals in line. You may need to rebalance if:

• Fluctuating market prices affect your asset allocation. For instance, if stocks get a lot more expensive, you may need to move some money from stocks to bonds.  
• Your investment goals change. Sometimes, you need to rebalance your portfolio based on life’s happenings. For instance, you might move money into bonds to protect your savings before buying a house, or move money into stocks because you think you’ll need more money for retirement. 
• Interest rates move. Bonds and interest rates have an inverse relationship. When interest rates drop, bond prices increase, and vice versa. When rates move, it may be time to buy or sell bonds to protect yourself or capitalize on the situation. 

Steps to rebalancing your bonds

Rebalancing your bonds can take time, but it doesn’t have to be a pain. 

Start by reviewing your portfolio against your goals and strategy. If you have too many bonds (e.g., you want to chase more aggressive growth), you could sell some bonds and buy stocks instead. 

During this process, also consider whether your asset allocation makes sense. Generally, as investors age, they get more financially conservative, depending on their goals. 

Portfolio rebalancing is easier if you check in regularly with your investments. But if you don’t, don’t worry — you can start today. 

If you use a robo-advisor like Wealthfront or Betterment, you can activate automatic rebalancing. The platform does the heavy lifting and you check in occasionally. 

Or, you can use a tool like Quicken’s all-in-one financial dashboard to keep a constant eye on your assets. 

Strategies to build a rock-solid bond portfolio

Mixing assets is one way to diversify your portfolio; mixing strategies is another. Consider whether the following methods could help you reach your goals. 

Bond ladders

Building a bond ladder means buying bonds that mature on different dates. As each bond matures, you can cash out or reinvest the money into new bonds with new maturities. 

If interest rates fall before your ladder matures, you may get lower yields but more valuable bonds. If interest rates rise, you can reinvest your money at higher rates.

Laddering bonds can:

• Reduce the impact of market downturns on your portfolio
• Minimize your exposure to interest rate risk
• Generate consistent income

Using bond funds and ETFs

Bond funds can immediately diversify your portfolio, spreading your risk and dollars efficiently. 

These mutual funds pool investor funds to buy a broad range of assets that fit a certain strategy or goal. Bond ETFs buy a “basket” of bonds and issue ownership through shares that trade on exchanges.  

Bond types of funds offer the ability to immediately diversify your bonds across risks, maturities, interest rates, and sectors. Funds often offer relatively high liquidity so you can quickly buy and sell your shares. 

However, neither fund can protect you from interest rate or credit risks. Plus, you don’t get to choose or reject each individual bond in the fund. 

Reinvesting interest payments

Investors can usually choose to tap their bond income immediately or reinvest the money into new bonds. Reinvesting your capital gains deploys the power of compounding. (Where buying more holdings generates greater income potential, which increases your holdings, and so on.) 

Many brokerages, robo-advisors, and funds offer automatic investing. All you have to do is activate this option and watch your bond interest payments buy more bonds.   

Partnering with a financial advisor for smart bond diversification

Proper diversification requires time, research, and understanding your goals. You could do that yourself — or you could hire a professional.

How a professional can enhance your strategy

If you’re nervous about managing your investments alone, consider bringing a professional on board. The right financial advisor can help you:

• Determine your needs and goals
• Design a customized investment plan 
• Keep you emotionally and financially on track

Plus, some advisors offer access to exclusive investment opportunities you couldn’t otherwise access. 

Questions to ask your financial advisor

Before hiring a financial advisor, ask important questions, like:

• What kind of fees do they charge? How much?
• What experience do they have with bond investing?
• How will they help you set and meet your goals?
• What strategies do they use to keep investors on track during crazy markets?

Any good financial advisor should be able to answer these questions. The best can start (or keep) you on the path to growing wealth, meeting your goals along the way, and retiring in style.