23 Jul Bond breakdowns in today’s market

 Q. I’m 40 and I have 40 percent of my assets in bonds. What’s the best breakdown given my long time horizon for retirement and today’s market?

A. This is an interesting time to be a bond investor.

The risk around an eventual “rate hike” has been a topic of discussion for many years now, with the latest expectations for a rate hike coming sometime in late 2015 or early 2016, said Chadderdon O’Brien, a certified financial planner with Lassus Wherley in New Providence.

Bonds and interest rates have an inverse relationship. When interest rates rise, the value of an existing bond will fall, O’Brien said.

“Regardless of the timing of interest rate movements, diversification among your fixed income investments is critical,” he said. “The topic of diversification is often limited to equity investment; however, it is just as important within the fixed income category.”

O’Brien said when it comes to diversification among bonds, he likes to see allocations to various fixed income categories, yields and maturity structures because it helps to reduce both interest rate and credit risk.

“Similar to diversification among equities, the net effect creates a portfolio with favorable long-term risk and return attributes,” he said. “No load, low expense bond mutual funds are a great way for investors to achieve fixed income diversification in a cost-effective way.”

Your bond allocation matches your age, and many investors choose their allocation to bonds based on that easy “subtract your age from 100” formula to figure out stock and bond allocations.

But O’Brien said bond allocations and exposures shouldn’t be purely a function of age. Rather, he said, the appropriate bond allocation should be driven by your investment needs and goals. You said your time horizon is long, but it also seems you are aware of the current environment and would like to manage risk as well.

To better understand risk, you need to understand the default risk (credit risk), time to maturity and interest rate sensitivity of a bond.

O’Brien said default risk can be quantified using the credit rating attached to a bond. The higher a credit rating a bond contains, the lower the risk of default.

Longer maturity bonds typically contain higher risk than shorter maturity bonds, and tend to have higher interest rate risk, he said.

Note that bond mutual funds publish this information so investors can better understand the risk profile of their funds.

Then there’s duration, which is a term used to estimate the sensitivity of a bond to changes in interest rates. Duration is a commonly used measure of interest rate risk. While not a perfect measure, it is a good starting point to better understand how you are invested, O’Brien said.

“In general, the higher the duration and term to maturity, the higher the risk,” he said. “In periods when interest rates are expected to rise, lowering the duration on your bond portfolio is a tool to reduce risk.”

But there’s a trade-off in keeping duration too low. Because lower duration bonds contain lower risk, they tend to offer lower yields. A bond portfolio maintaining a very short duration and maturity profile will likely underperform a more moderately allocated bond portfolio over time, he said.

At present, the Barclays US Aggregate Bond index, which is a widely used benchmark for core bond investment, has an average maturity of around 7 years and a duration of around 5, he said.

“Given your time horizon, you may be well served maintaining maturity and duration exposure in the same ranges as the index,” he said. “Reducing your exposures below these ranges will reduce your risk relative to the index.”

In addition to managing interest rate risk, you can also diversify your holdings, and reduce your credit risk, by allocating across fixed income markets.

“For example, utilizing a portfolio that employs high quality corporate, municipal, government and asset backed securities can reduce risk,” O’Brien said. “Layering in exposures to international bonds, both government and corporate, will improve your diversification as well.”

So given your long-term time horizon, a high-quality diversified bond portfolio with moderate interest rate risk will likely provide your portfolio with the stable base it needs, O’Brien said.

For example, O’Brien said, you may want to consider having 40 to 50 percent of your bond portfolio in a core bond fund that provides exposure to corporate, government and asset backed securities. Five to 10 percent of this allocation can be reserved for international bond investment.

With the remaining 50 to 60 percent of your bond portfolio, you may consider using funds with a shorter term focus, he said.

Overall, this approach may result in a portfolio with an average maturity between 5 and 6 years, with a duration of approximately 4.

Jody D’Agostini, a certified financial planner with AXA Advisors/The Falcon Financial Group in Morristown, said given your long time horizon, you can generally take on more risk.

But the real answer to your question depends upon what you have already saved and what your risk tolerance really is.

Plus, your overall portfolio needs to keep up with inflation. If you have 40 percent in bonds, we’ll assume the other 60 percent is in stocks, and stocks are a good inflation-protector.

“Having an asset allocation with at least this amount in stocks most likely makes sense, but it should be held in context of your overall financial plan, and the savings that you have accumulated to date,” D’Agostini said. “I would also be sure that to diversify your portfolio amongst other asset classes to get less volatility with less risk.”

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This story was first posted in July 2015.