All bonds are not created equal. Diversifying your fixed-income portfolio may help you more effectively balance risk and return potential. There is a wide variety of fixed income instruments available, with varying maturities, credit qualities, and currency exposures to consider in building your fixed income portfolio. Although, you should be aware there is no guarantee that diversification, or a specific asset allocation, will meet your investment objectives, generate a specific amount of income or protect you from loss in declining markets.
For some types of bonds, such as U.S. Treasury securities (which are backed by the full faith and credit of the U.S. government), the risk that the issuer may default on a payment of interest or principal is extremely low. However, modest yields generally accompany this high degree of credit quality. If you seek to capture higher yields by investing in lower credit quality securities, diversifying among different issuers may help reduce your total exposure in the event of any single issuer’s default. Be aware that bonds rated below investment grade have speculative characteristics and present significant credit and default risks beyond those of other securities. You should consider these risks alongside your investment objectives and risk tolerance before investing. High yield securities should comprise only a limited portion of a balanced portfolio.
Longer-term bonds generally offer higher yields, but are more sensitive to interest-rate fluctuations than similar coupon shorter-term issues. Some risk-averse investors may choose to purchase only short-term issues, settling for a lower yield. Other investors choose longer-term bonds for higher return potential, taking on more market risk. Choosing a range of issues with staggered maturities, perhaps through a laddered portfolio, may help improve return potential and reduce interest rate risk, depending on the interest rate environment.
Many investors who are in the higher 28 percent to 35 percent tax brackets gravitate towards municipal bonds primarily for one reason: tax-exempt income. Income from municipal bonds is generally federally tax-exempt, and if issued in your state or local city of residence, may also be state and local tax-exempt. Please take into consideration some municipal bonds may be subject to the federal alternative minimum tax. Many municipal bonds are considered second to Treasuries in terms of credit quality, which adds to their appeal.
The large domestic market for individual bonds offers many choices, such as U.S. Treasury, inflation-protected, tax-advantaged municipal, mortgage-backed, preferred and corporate securities, but there is also an entire world of bonds beyond our borders. Foreign governments and corporations also issue bonds, many of which are denominated in foreign currencies, while others are denominated in U.S. dollars. While enhancing diversification, investing in foreign markets also entails greater risks than those normally associated with domestic markets, including political, currency, economic and market risk. International investing should comprise only a limited portion of a balanced portfolio.
As with all investments, fixed-income securities have inherent risks. These risks include credit risk, interest rate risk, market risk, reinvestment risk and call risk. In particular, should you sell your security in the secondary market, the price you receive may be more or less than your original purchase price or maturity value.
If sold prior to maturity, investments in fixed income securities may be subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer.
Gary W. Plum, first vice president of Morgan Stanley Smith Barney in Bradenton, can be reached at (941) 714-7939.