How to Build a Bond Portfolio
We believe bonds are important for diversification, stability and income.
The bond market is large and complex, so it’s important to know what’s in your portfolio.
Dividing bonds into three categories—core bonds, international bonds and aggressive income bonds—can be a good start toward building a diversified fixed income portfolio.
The global bond market surpasses the global stock market in terms of both size and complexity. This can pose a challenge to investors looking to build a portfolio of bonds or bond funds. In a market teeming with investment possibilities, what’s the best way to build a bond portfolio that can provide stability and income and is also diversified enough to help manage credit and interest rate risk?
The short answer is to think about the role each security will play in your portfolio. Are you looking to add diversification? Stability? Income?
Here we will address some common questions you may have when allocating part of your portfolio to bonds.
Where do I start?
For most investors, we believe that a bond portfolio composed primarily of high-quality, investment-grade bonds or funds focused on such bonds makes sense. Many investors may also be thinking about high-yield junk bonds or foreign-currency bonds given how much the bond market has changed in recent years. A globally diversified portfolio may include exposure to bonds with higher credit risk and beyond the U.S. as well.
How much exposure should I have to higher-risk sectors?
Whether investors should also include an allocation to higher-risk sectors such as U.S. corporate high-yield bonds or developed or emerging market foreign-currency bonds may depend on their risk tolerance, objectives and preference for increased diversification or personalization in their portfolio.
It may help to think of bonds as falling into three different categories: core bonds, international bonds and aggressive income securities. This table ranks the three in terms of volatility (in other words, risk). In general, the higher the risk, the less diversification a bond offers relative to stocks. That said, riskier bonds may also offer higher income potential.
Three fixed income categories
Source: Schwab Center for Financial Research, Barclays, Bloomberg. For illustrative purposes only. Please see the disclosures below for indexes used. Average annual return refers to the average total return for each sector, based on index returns from 2/2009 to 2/2019. Max/min rolling 12-month return refers to the maximum (highest) and minimum (lowest) annual return, using index returns during the period. Yield to worst means the current average yield for the representative index assuming bonds are called at their earliest call date, also known as yield to “worst.” This example does not reflect the effect of taxes or fees. Past performance does not guarantee future results.
Why not go all aggressive?
If aggressive income bonds—such as high yield bonds and emerging market bonds—offer higher average annual returns than core bonds, why not just go all aggressive?
Core bonds provide what stocks and aggressive income investments often do not: greater stability and liquidity. That means they can help with diversification and make it easier to stomach risk elsewhere in a portfolio. As you can see in the table below, riskier bonds tend to be more highly correlated with the S&P 500® Index than core bonds.
Higher returns come with higher risks
Source: Schwab Center for Financial Research, Barclays, Bloomberg. Please see the disclosures below for indexes used. The chart shows correlation of monthly index returns to the S&P 500 Index, as of 5/31/2019.1 Past performance does not guarantee future results.
That’s why we recommend starting with a portfolio of investment-grade core bonds and then adding riskier bonds, based on your tolerance for the risks, to provide diversification and boost potential return and income. Keep in mind, though, that areas of the bond market with higher credit risk can behave more like stocks in a down market. So moderation makes sense, for any asset class in any portfolio.
Should I build a portfolio with bonds or bond funds?
You can use either bonds or bond funds to create your allocation to investment-grade core bonds. Neither is better or worse, in our view. It may depend on your preferences. For higher-risk or more complex investments in the international or aggressive income categories, we generally suggest using diversified bond fund or funds—or fund managers—to help.
If you prefer individual bonds instead of bond funds, we suggest holding at least 10 different individual issues for diversification purposes. While investments in many bond investments may be made in denominations as low as $1,000 per bond, the appropriate amount to invest is determined by an individual’s goals and objectives due to risks and liquidity purposes.
The table below shows the Morningstar Bond Fund categories. Schwab clients can use these categories to search for funds at schwab.com/funds.
You don’t need funds in every category—or even most. If you’re in a high tax bracket, consider the “Municipal Bond” categories for most investments held in taxable (non-retirement) funds.
Select Morningstar bond fund categories can help you build a bond fund portfolio
Source: Schwab Center for Financial Research, Morningstar. The list of sectors is partial, not comprehensive, but represents the primary Morningstar fund categories that we think investors could start with in each sector. For fund ideas and recommendations, see the www.schwab.com/selectlist. “World Bond” is a Morningstar category that this article uses interchangeably with “international (non-U.S.) bond.”
A sample portfolio
The table below shows a Schwab “moderate conservative” model portfolio with a 60% allocation to bonds and cash investments and a 40% allocation to stocks. Investors can use Schwab’s Select Lists to find bond funds in the core and aggressive income categories.
Sample portfolio using core, international and aggressive income bonds
Source: Schwab Center for Financial Research, based on Schwab model portfolios. The allocation to international bonds and aggressive income would be for investors willing to accept increased volatility in exchange for diversification and potential for higher income. Hypothetical example for illustration only.
1Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated.