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New Ways to Diversify Your Bond Portfolio
There have been some exciting developments in the fixed income world that allow for greater diversification and ease of investing in this most important asset class. Bonds are a staple in a well-diversified investment portfolio. Yet bonds have been more difficult to buy and sell than stocks. Prices often are not readily available. And, unless you have a sizeable portfolio, diversifying your bond holdings can be problematic.
Simply put, a bond is a loan, and you are the lender. By buying a bond you lend money to a company, municipality or the government. These institutions have the use of your money in exchange for interest payments. Your principal, or the amount you loaned, is repaid at the end of the term of the loan. The beauty of bonds is they provide a steady income stream and are less risky than stocks.
The Beauty of Exchange Traded Funds
You may have heard about exchange-traded funds, or ETF’s. They are investment vehicles that are traded on exchanges much like stocks are. An exchange-traded fund can contain many types of assets, such as stocks, bonds and commodities. You can buy large amounts of these funds or just a few shares.
ETF's have many advantages. One of the most important is that they tend to have many different holdings. That is to say if you bought a corporate bond ETF you would own a basket of over 200 bonds from some well-known companies. By purchasing one ETF you could own a well-diversified basket of bonds!
Another great advantage of ETF’s is that they tend to have very low expense ratios. The expense ratio tells you what it costs to own the fund each year. The fund company deducts a percentage from the portfolio yearly for management of the ETF.
The average bond mutual fund costs about three quarters of one percent per year to own. A bond ETF may only cost .15 percent annually. It may seem a small difference, but with bond investments, as with investments in general, investors need to be mindful of expenses. They ultimately detract from our returns.
ETF's Make It Easy To Diversify
The most exciting advantage of using bond ETF’s as an investment tool is the ease of diversification they offer the investor. Bonds come in many types and flavors. U.S. Treasury bonds are the safest and most common. There are also municipal bonds and corporate bonds.
Corporate bonds of higher risk companies, paying higher dividends, are called high yield bonds (in the past referred to as junk bonds). Convertible bonds have characteristics of both bonds and stocks. They pay interest and have the potential to rise in value as the stock of the company appreciates. Inflation protected bonds have an interest payment that increases with the rate of inflation. And, you can even invest in the government bonds of foreign countries.
Bond exchange-traded funds are an excellent, low-cost way for individual investors to diversify their fixed income portfolios. They are easy to buy and sell. While there is only space in this column to discuss the virtues of ETF’s, it is vital to remember that all investments involve some form of risk. As with any investment, do not invest until you understand the risks.
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Jeffrey Stoffer CFA CFP | jeff@stofferwealthadvisors.com | 415.706.7800
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