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Why Buying What You Know May Be a Bad Thing

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The bond markets are large and complex, and it takes a lot of homework to find bonds to invest in that fit your needs. Plus, with all the headlines of bankruptcies and defaults, and the low interest rates we continue to see, this isn't an easy question to answer.One mistake many investors make is that they stick with what they know and only invest in those bonds. 

At Schwab, we agree that investors should fully understand the investments they own. But there are ways to broaden the scope of what you know, and we want to help you do that. Too often, investing in only what you know results in owning too much from one issuer or in one sector. 

You’re counting on the issuers of your bonds to pay interest and principal as promised. 

But unforeseen circumstances that cause financial distress can impact an issuer. And if your portfolio has multiple bonds from the same issuer, you could find that your return and even your principal could be in jeopardy. And with high quality fixed income serving as part of your portfolio that is meant to help preserve your capital, this wouldn’t be a good outcome. Let’s look at municipal bonds as an example. 

It can certainly make sense to invest a significant portion in bonds issued in your home state for the tax-exempt interest the bond may generate. But this doesn’t mean you need to invest only in your home state. Sometimes the after tax yield you can receive when you buy out of state bonds is higher than buying in-state. Buying out of state can also provide better credit risk diversification. Additionally, having too much in one issuer can create concentration risk. 

There are over 60,000 municipal bond issuers out there. 5,000 of them are from California alone.

Similarly, with corporate bonds, it’s important to diversify not only by issuer, but also by sector. 

Just because you have a number of different companies in your portfolio does not mean you’re diversified. Take the financial sector for example; you could have bonds from a number of different companies. 

Unfortunately the entire sector could face a downturn or a market event. And that diversification within the sector may not be enough. Additionally, for both corporate and municipal bonds, there are typically many different bonds that come from the same issuer. And they may have very different risk profiles including credit risk and call risk. 

It’s important to put in the work to understand both the issuer and the issue. This leads us to the next question: with all those choices, how do I find the right one? It used to be much easier with municipal bonds when you could count on insurance to back up the bonds you bought. 

It can be much harder now, and you need to pay attention to the fine print and make sure the bonds you’re buying are designed to meet your needs. Many investors, however, find that even if they have the time to do the analysis in the beginning, they don’t want to spend the time to keep up with it all. 

This is where a professional manager may be able to help you. They can help you stay on track and ensure you stay diversified.

Some investors own too much from one issuer or sector and may be putting their portfolio at risk. 

Important Disclosures

The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

Tax-exempt bonds are not necessarily a suitable investment for all persons. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

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(0315-1970)

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