Building a bond portfolio requires careful planning and strategy, especially for investors seeking income and stability, such as retirees. While it requires effort and expertise, there are several proven strategies investors use to construct a diversified bond portfolio that aligns with their financial goals.

Investors face several risks when investing in bonds, each affecting their investments differently:

  • Interest-rate risk: Changes in interest rates impact bond prices. Rising rates generally decrease bond prices, especially for bonds with longer maturities.
  • Reinvestment risk: Investors may face lower interest rates when reinvesting proceeds from matured bonds, potentially reducing overall returns.
  • Credit risk: Bonds carry the risk that issuers may default on payments. This risk varies based on the creditworthiness of the issuer.
  • Liquidity risk: Bonds can be less liquid than stocks, impacting the ease of buying or selling them without affecting their price significantly.

To manage these risks, investors carefully select bonds for their portfolios.

Here are five commonly used strategies for constructing a bond portfolio, along with explanations of how they operate and the main risks they help manage.

The simplest strategy to implement is the buy-and-hold strategy. As its name implies, you purchase a bond and retain it until it matures. Throughout the bond’s life, you’ll receive regular interest payments, and upon maturity, you’ll receive the bond’s face value.

Advantages: This approach eliminates liquidity risk, as you intend to hold the bond until maturity. Interest-rate risk is also mitigated if you hold the bond to maturity. However, if you need to sell the bond before maturity, you may be exposed to interest-rate risk if prevailing rates have risen since your purchase.

Disadvantages: You still face reinvestment risk, which arises if future investment opportunities yield lower returns than your current bond. To reduce credit risk, consider diversifying your holdings across multiple issuers or selecting bonds from high-quality issuers.

A bond ladder is a popular investment strategy designed to mitigate key risks associated with bonds. With a bond ladder, an investor purchases bonds with staggered maturities—such as one year, two years, three years, and so forth. When a bond matures, the principal is reinvested at the longest maturity of the ladder. For instance, when a one-year bond matures, its principal is reinvested into the longest maturity, adjusting the ladder accordingly.

Advantages: This strategy effectively reduces reinvestment risk because you continuously reinvest funds as bonds mature. It allows you to benefit from rising interest rates with new bond purchases, while minimizing exposure if rates decline. While some interest-rate risk remains, it is mitigated compared to holding bonds with uniform maturities. By holding bonds to maturity, liquidity risk is eliminated, and diversifying across various issuers helps mitigate credit risk.

A bond barbell strategy involves holding short-term bonds and long-term bonds with no intermediate maturities. As bonds mature, the investor can reinvest the capital into either short-term or long-term bonds, depending on market conditions or personal preferences.

Advantages: This strategy helps mitigate reinvestment risk by allowing flexibility in choosing between short-term or long-term bonds based on prevailing interest rates at the time of reinvestment. If interest rates rise, investors can opt for short-term bonds for quicker reinvestment at higher rates. Conversely, if rates are lower, they can choose long-term bonds for potentially higher yields on that end of the barbell. However, reinvesting in longer maturities exposes investors to increased interest-rate risk.

By holding bonds to maturity, liquidity risk is eliminated, and diversifying across various issuers helps mitigate credit risk in constructing the bond barbell.

The bond bullets strategy involves purchasing bonds with staggered maturities that align with specific financial needs. For example, if you anticipate needing capital in five years, you would buy bonds with maturities spread out over that period. Each bond matures at a different point, ensuring you have access to funds when needed.

Advantages: This strategy provides ready cash at predetermined intervals while aiming to maximize returns over the chosen time horizon. By holding bonds to maturity and aligning maturities with financial needs, you can avoid interest-rate risk associated with fluctuating market rates.

Reinvestment risk may vary depending on your plans for the cash received from maturing bonds. If reinvestment is necessary, having multiple bonds mature simultaneously can increase reinvestment risk, as you may need to deploy a large amount of cash at once.

Liquidity risk is minimized because the strategy involves holding bonds until maturity to meet specific financial goals. However, if unexpected cash needs arise before bonds mature, liquidity risk could become a consideration. Diversifying across various issuers helps mitigate credit risk within a bond bullets strategy.

A bond exchange-traded fund (ETF) offers various portfolio strategies tailored to investors’ preferences. Some ETFs focus on short-term bonds to minimize interest-rate risk but may increase reinvestment risk. Others maintain a diverse mix of bond maturities, balancing both reinvestment and interest-rate risks.

Additionally, some ETFs specialize in high-yield bonds, which carry higher risk but potentially higher returns, while others concentrate on lower-yielding municipal bonds, which offer tax advantages.

Advantages: Bond ETFs allow investors to select specific segments of the bond market without purchasing individual bonds. ETFs typically provide well-diversified exposure across bond issuers, thereby reducing credit risk. The performance of ETFs is influenced by the types of bonds they hold; for instance, ETFs optimized for declining interest rates may perform well in such conditions but could be exposed to risks like rising rates in other scenarios.

The bond market typically lacks the liquidity of the stock market, making it challenging for individual investors to trade bonds easily. Therefore, bond ETFs offer a compelling option for investors seeking diversified exposure to the credit market while mitigating various significant risks.