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Friday, November 26, 2010

Thoughts For The DIY Investor On Building a Bond Portfolio


Suppose we are a fly on the wall (actually in Maryland a stink bug is more appropriate - we've been inundated with them!) and looking in on a DIYer who has completed his asset allocation work and has come up with a percentage of assets to put into the fixed income. Just focusing on these fixed assets, how should they be specifically allocated?

Every situation is a bit different, but here is one approach.

First off, unless he has been living under a rock, the DIY Investor has heard a lot about the so-called "bond bubble." If he hasn't, he should use an advisor.

Should he buy individual bonds or buy funds? If he has the time, resources, and know-how, he can be my guest and buy individual bonds; but I generally recommend against it because individual bonds are illiquid, very difficult to price, and it is almost impossible to determine if you are getting good execution. To do it right, you almost have to use multiple brokers. All of these disadvantages can easily be overcome by using funds.

So, the DIYer makes the smart move, IMHO, and heads down the fund path. Let's assume he will use exchange traded funds. Warning: if he will make a lot of transactions, he should be aware of commissions! There are some commission-free ETFs, but most still have a commission.

Choices
Exchange traded bond funds provide a bewildering array of choices. From behavioral finance, we know this can be both good and bad. Some DIY Investors will exploit the available choices; others may freeze up and not be able to choose. Among the choices are corporate bond funds, Treasury bond funds, international bond funds, municipals, and agency bond funds.

Secondly, he will need to think about maturity. Other things equal, the longer the maturity of a bond, the more volatile the price. In his investigation, the DIYer finds that the typical grouping is in terms of short-term, intermediate-term, and longer-term bond funds.

From previous posts, the DIY Investor has learned about the yield curve and about a source of comprehensive information for Exchange Traded Funds. Thinking about the yield curve and the bond bubble, he develops a game plan for his fixed income assets positioning. He realizes that, first off, it is impossible to predict interest rates. If he could predict interest rates, he would be at Salomon Brothers making a zillion $s/year as a bond trader.

With these thoughts in his head, and respecting the bond bubble idea, he puts half of his fixed income allocation into the overall bond market by using AGG. AGG tracks the Barclay's Aggregate Bond Index - it captures the overall U.S. bond market. Under more normal circumstances, the DIY Investor would have considered investing up to 75% of his bond position in AGG.

Next, he would look at CSJ, a shorter-maturity ETF comprised of non-U.S. government names. CSJ presently has a yield of 2.79%. Holdings can be found on Yahoo Finance. He decides to put 25% of his fixed income assets into CSJ.

The remaining 25% he might spread around to high-yield bonds (HYG), emerging markets bonds (EMB), and mortgage-backed securities (VMBS).

There are, of course, many other choices for the DIY bond investor, but this at least has him started on a well-diversified, low-cost, low- turnover approach to the bond market that takes advantage of bond exchange traded funds.

This post is intended for informational purposes only. Specific investments should be undertaken only after completing research and consulting a professional advisor. I hold some of the ETFs mentioned.

1 comment:

  1. Is the stink bug a fitting symbol for bonds these days?

    ReplyDelete