How should you allocate your bond portfolio?

In any well-diversified portfolio it’s critical that investors have exposure to the fixed income or bond market.  When we allocate our clients’ portfolios, the fixed income portion can range from 20% to 60% of their total portfolio depending upon their indvidual risk tolerance and cash flow needs.  In the current market environment, where 10-year treasury bonds are yielding approximately 2% and the spread between a 10-year treasury bond and junk bonds are so low that the extra risk may not be worth taking, where can investors go and how should they allocate their portfolio to gain exposure to the fixed income market?

Bonds are currently riding a 30 year winning streak, with prices continuing to rise and yields continuing to fall.  Five years ago, investors were able to get a CD with an approximate yield of 5%, but as the CDs begin to mature, there is no place to go in the market to get a similar yield with an equivalent level of risk.  The other issue is that most economists and investors feel that it is only a matter of time before the Federal Reserve will decide to raise interest rates, causing the price of bonds to drop.  So between searching for yield and finding protection from rising interests rates, fixed income investors have many complicated issues to navigate.

Regardless of an investors risk tolerance and the size of their alloction to bonds, they can structure their fixed income portfolio in a similar manner to help protect against some of these risks.  To begin with, the core holding of the bond allocation should limit portfolio volatility and provide diversification from equities.  This is achieved through high quality / low duration bonds.  While this type of holding will have a limited yield, it does produce some income and provides protection from the potential of rising interest rates more effectively than longer duration bonds.

The next element of the bond allocation we define as yield enhancement fixed income and these holdings are designed to provide additional yield while limiting interest rate risk.  These investments include emerginig market debt, high yield bonds and preferred equity.  To gain this additional yield, additional risk is incurred but these holdings provide diversification from both equities and the core bond holdings.

The final element to limiting exposure to bonds is to gain income from alternative investments such as Master Limited Partnerships (MLP’s), Real Estate Investment Trusts (REITs), and absolute and global macro investments.  These holdings provide additional yield and diversificttion to the equity portion of the portfolio.  MLPs are publiclicy traded partnerships that provide exposure to the transportation and storage of oil and natural gas while REITs provide exposure to commerical real estate with holdings in apartment complexes, shopping malls, and commerical office space.  Finally, the absolute return and global macro investments give money managers a great deal of flexibility in structuring their portfolios, and while they may not appreciate in a similar manner as equities, they do provide diversification to equities.

It is through a combination of these types of investments that investors can receive income from their portfolio while providing diversification from equities and limiiting exposure to rising interest rates.