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Do You Need to Diversify Your Bonds?

We spend a lot of time talking about the importance of diversification. When it comes to stocks, it’s foundational to our investment approach. Investing in a stock portfolio that isn’t properly diversified is like swimming with sharks without a shark cage. You can do it, but there are safer ways.

But that’s stocks. Bonds are a whole different story. If they were The Odd Couple, stocks would be unpredictable Oscar and bonds would be good old, reliable Felix.

Diversification Is Your Best Friend When It Comes to Stocks

As we’ve discussed previously, bond returns are relatively predictable. We know what two out of the three components of a bond’s return will be as soon as we buy it.

In contrast, stock returns are wildly uncertain. We can make rough, tentative statements about the returns big groups of stocks will earn over long periods of time. We can point to the differences in risk we believe will benefit disciplined, long-term investors.

But in order for those things to be as true as they are, we need to be working with throngs of stocks, minimizing as much of the noise of individual companies as we can.

In other words, diversification is our friend – best friend, really. We want a piece of pretty much every stock so we don’t miss out on the good returns. With stocks, we need a really good reason to move away from market weightings, in both domestic and international markets.

But When It Comes to Bonds…

We have to look at bonds a little differently. All investments are driven by their systematic risks, but the risks that bonds face are different than the risks that stocks face. And, thankfully, when you realize that bonds are just fancy loans (and really they’re not actually all that fancy), the risks that bond investors need to deal with are pretty straightforward.

Default Risk

Default risk is fairly self-explanatory – it’s the risk that the bond issuer will default and not make the promised payments. This is essentially the company-specific risk of the bond world.

The great thing about bonds is that we can get a pretty good idea of which ones have a higher chance of default. Not only can we look at bond ratings from organizations like Moody’s or Standard and Poors (yes, the S&P from the S&P 500 Index), we can also just look at the bond’s price – if a bond is cheaper than a comparable bond from another issuer, there’s probably more default risk in play

With stocks, you’re worried about whether a company will do better or worse than expected. With bonds, you only care whether they can make the scheduled payments.

For instance, if GE has a bad quarter, they’re big and stable enough that they’ll still be able to pay off their bond holders. But if a company that’s flirting with bankruptcy has a good quarter, they still might very much be at risk of not being able to make their bond payments.

Another bonus is that while you don’t get paid for taking on company-specific risk in the stock market, default risk offers some (although not much) compensation in the bond market.

Term Risk

Again, the name does a pretty good job of explaining this one. Term risk is the risk that comes from the loaning your money out for a longer period of time.

Think about mortgages. Typically, the interest rate that you would get for a 15 year mortgage will be lower than a 30 year mortgage.

The reason for this comes down to potential movements in interest rates (which is why term risk is sometimes called interest rate risk). There’s two things going on here. The first is simply that a longer term bond has a longer period for interest rates to move against it. But the second is that changes in interest rates have a bigger impact on longer term bonds (specifically bonds with more of their payments further out in time). A good way to think about is that the interest rate has more time to affect the future payments coming from a bond.

When you buy a bond, the payments are defined, but how much people will pay for those payments is constantly moving. Luckily, these moves are (usually) highly correlated across different bonds and markets. It might not be exact, but if interest rates in the US go up, you can expect them to do the same across the globe.

Diversification Isn’t as Important with Bonds

To put it simply, diversification doesn’t play as vital of a role in the bond markets as it does with stocks. It would mostly help with Default Risk, and that’s pretty easy to avoid on our own.

So we’re left with Term Risk, which is impacted by how the yield curve moves through time. Since any two random securities will probably move fairly similarly, we’re free to look for the highest expected return bonds we can find (that fit within the portfolio we want to build).

With global portfolios, that means we can look across all markets and choose based on specific yield curves. While changes in the yield curve are reasonably correlated across markets, they don’t move in perfect harmony, and we can move the portfolio around to take advantage of that.

There Are Still Risks

Sounds great, right? But you’ll run into some limits.

The big one is that holding foreign bonds exposes you to added volatility in the form of currency exposure, and that can wreak havoc on your portfolio (remember, bonds are supposed to be the boring one, not the wild card).

In order to tame our bonds, we need to hedge that currency exposure back to US Dollars. Two things happen when we do this:

  1. We have to pay to hedge our currency exposure. Someone is going to end up holding that currency risk, and they’re not going to do it for free. This cost, even though it’s usually not huge, puts a drag on the returns of foreign bonds. In other words, if you’re going to buy a foreign bond, make sure the differential makes it worth your time.
  2. Hedging everything back to the US Dollar effectively shifts the foreign yield curve so the risk-free rates line up. This is a little bit more technical (ok, a lot more technical), but basically, it means we’re focusing on the differences in the slope of the yield curves in different markets, rather than the specific levels.

Foreign bonds need to be able to overcome both of these issues to be worthy of a place in your portfolio. I’m not saying they’re bad, and I’m definitely not implying anything about the state of the foreign bond market – just that there needs to be enough of an advantage to owning the foreign bond to overcome these issues.

My point is that we really don’t want currency risk in our bond portfolio. This is not a chocolate and peanut butter situation. Currency risk will not make your portfolio more stable, lucrative, or delicious.

And that goes for any investor anywhere in the world. If we lived in the UK or Japan, we would want to hedge everything back to Pounds or Yen – and we would face the exact same issues.

But all of this hinges on two things (along with the predictability of bond returns):

  1. Avoiding serious credit risk. If we were buying junk bonds – or even middle or lower-tier investment-grade bonds – we would need to diversify. If a stock tanks, you might lose 20% or 30% of its value. If a bond defaults, it’s pretty much worthless.
  2. Focusing on reasonably correlated interest rate risk. If interest rates go up, they go up for pretty much everyone. So it doesn’t really matter how many different bonds you actually own, they will all (largely) be affected in the same way.

These two things give us the flexibility to target the bond portfolio and maximize return per unit of risk. If either of these assumptions failed, we would need to diversify bonds just like stocks.

Diversification is a tool. And just like any tool, you need to know when to use it.

In the stock market, it helps make investing more than just gambling. But in the world of bonds, assuming you set up your bond portfolio correctly, it just isn’t as necessary.

To find out more about how to build an investment portfolio that works for you, read our eBook 9 Principles of Intelligent Investors.

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