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 provides stability and income and is also diversified enough to 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 investors might have about this complex asset class.
Where do I start?
For most investors, a bond portfolio composed entirely of high-quality, investment-grade bonds or funds focused on such bonds would make the most sense. That many investors today might also be thinking about high-yield junk bonds or foreign-currency bonds is a measure how much the bond market has changed in recent years. While a small allocation to these relatively riskier bonds could be tempting as part of a more aggressive portfolio, we believe most investors should focus on the U.S. investment-grade market.
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 depends on their risk tolerance and objectives.
It helps 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. Please see below for indices used.1 Average annual return refers to the average total return for each sector, based on index returns from 3/2006 to 3/2016. 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.” 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 below for indices used.2 The chart shows correlation of monthly index returns to the S&P 500 Index, from 3/2011 to 3/2016.3 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 in smaller allocations to potentially boost income.
Should I build a portfolio with bonds or bond funds?
You can use either for the investment-grade core bonds. For higher-risk or more complex investments in the international or aggressive income categories, we think a diversified bond fund or active fund management would help.
If you prefer individual bonds instead of bond funds, we suggest you invest at least $100,000 if you’re planning to create a corporate or uninsured municipal bond portfolio (for a diversified portfolio of bonds from 10 issuers, $10,000 per bond).
The table below shows the Morningstar Bond Fund categories. Schwab clients can use these categories to search for funds at schwab.com/funds. Focus on the bolded categories if you want a simple but comprehensive portfolio. You don’t need funds in every category—or even most. If you’re in a high tax bracket—above 28%—consider the “muni” category for investments held in taxable (non-retirement) funds.
Morningstar bond fund categories can help you build a bond fund portfolio
Source: Schwab Center for Financial Research, Morningstar.
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.
What to do now
For help with your fixed income allocation, talk to a Financial Consultant or Schwab Fixed Income Specialist. If you’re a Schwab client, you can use the Schwab Portfolio Checkup tool to look at your allocations to stocks and bonds, including to each of the bond categories above.
For help choosing mutual funds or exchange-traded funds in each category, search the Schwab Select Lists by Fund Category.
For help, call a Schwab Fixed Income Specialist at 800-626-4600.
1U.S. Treasuries are represented by the Barclays U.S. Treasury Index. U.S. corporates are represented by the Barclays U.S. Corporate Bond Index. Municipals are represented by the Barclays U.S. Municipal Bond Index. Non-U.S. bonds are represented by the Barclays Global Aggregate ex-USD Index. U.S. corporate high yield is represented by the Barclays U.S. Corporate High Yield Index. Emerging markets bonds are represented by the Barclays Emerging Markets USD Aggregate Bond Index. Preferred securities are represented by the BofA Merrill Lynch Fixed Rate Preferred Securities Index.
3Correlation 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.
Talk to Us
- Call a bond specialist at Schwab anytime at 877-908-1072.
- Talk to a Schwab Financial Consultant at your local branch.