4 Important Considerations When Building Bond Portfolios

Last Updated Nov 8, 2010 5:57 PM EST

(This article is part of a series on building bond portfolios. For more on this topic, see the post "How to Build a Bond Portfolio.")
Building bond portfolios using a laddered approach is the right strategy when enough assets are available. This gives you the best chance of mitigating both price risk and reinvestment risk of your bonds.

Before we get into what you need to consider before building a laddered bond portfolio, please keep in mind that this strategy makes sense at a certain asset level. At my firm, for example, the bond portion of the portfolio should be at least $500,000 before implementing a laddered approach (though a laddered CD portfolio can be built with much smaller amounts).

If this strategy makes sense for you, here's what you should watch for in building your portfolio.

Bond/Stock Correlation The longer the maturity of your bonds, the greater their correlation with the equity assets in the portfolio. Thus, while you reduce reinvestment risk when you extend maturity, you increase the price risk of the fixed-income assets and you also increase the risk of the overall portfolio.

Rewards Not Worth the Risk The historical evidence for taxable bonds is that, on average, investors haven't been well rewarded for extending maturities beyond five years. (Remember that the yield curve is typically steeper for municipal bonds.)

Capturing Incremental Returns When It Makes Sense The best predictor of future yield curves is today's yield curve. Thus, you're likely to achieve the highest return by extending maturity until the point where the yield curve is no longer upward sloping.

When to Take Additional Risk Keep in mind that extending maturity means accepting more risk in your bonds and in your overall portfolio. Thus, it seems prudent to establish a rule of thumb that requires a minimum incremental yield for each additional year of maturity as compensation for the incremental risk:
  • For taxable investments, a suggested hurdle is 0.20 percent per year.
  • For municipal bonds, a suggested hurdle is 0.15 percent per year.
However, if the yield curve is flat or negatively sloped, you'll end up creating a portfolio that's very short term in nature, with little price risk and great reinvestment risk. Thus, a second requirement might be having a minimum and maximum weighted-average maturity for the ladder. For example, the minimum weighted-average maturity might be three years and the maximum might be five years.

More on MoneyWatch:
The Economy Isn't the Same as the Market For Bonds, Yield Doesn't Always Equal Return 4 Reasons Investors Avoid Investing Internationally Why Buy-and-Hold Isn't a Good Strategy Are Stocks Really Doomed?
Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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