Corporate bond portfolios need diversity

Most investors know the rules when it comes to equity investments — diversify among holdings, limit correlation, buy low, sell high — and some of them even follow those rules. Yet when it comes to fixed income investing, that knowledge seems to go out the window.

The appeal of highly-rated bonds is logical to an extent, since these are the investments that are meant to provide a “guarantee” for the holder. Why take on excess risk in the safe part of your portfolio? Well, because it apparently limits your overall risk and boosts returns, according to a report from international investment giant UBS Wealth Management Research.

Corporate debt offers higher yields than sovereign debt, so these bonds can hold an important place in the overall fixed income portfolio. In a paper on how the private investor can best improve their corporate bond portfolio, UBS offers five key recommendations.

1. Use credit risk to optimize your bond portfolio

The report suggests that too many individual investors buy only AAA and AA rated bonds, which, while safe, offers sub-optimal performance due to these bonds’ low yield. The addition of a few high-yield (formerly known as “junk”) bonds can raise the overall yield of the portfolio.

2. Diversification is a key principle of corporate bond investing

While the benefit of diversification is well known in the equity market, many investors forget this simple rule when it comes time to construct their corporate bond portfolio.

“Since corporations can go bankrupt, it is not prudent to concentrate bond holdings on only a few issuers,” the report says. “The risk of a corporation going bankrupt is a diversifiable risk that can be effectively managed by holding a portfolio with many different issuers.”

This principle goes hand in hand with the aforementioned credit risk diversification. As the investor adds bonds to their portfolio, they should ensure that they have a mix of investment grade and high yield. Loading up on a number of bonds from the same issuer, or even within the same sector, limits downside protection.

But a properly diversified corporate portfolio could require dozens of issues, placing it out of reach for the average investor.

“Diversified corporate bond funds can represent an effective solution,” the report suggests. “Alternative structured credit products which already provide a diversified credit exposure, such as asset-backed securities (ABS) and collateralized debt obligations (CDO), also represent an appropriate solution.”

3. Examine novel investment instruments in credit

Pension funds have all but dried up the AAA and even the AA market. Investors who prefer the lowest possible risk may find it easier to buy ABSs and CDOs, which have been tailored to this market.

“This has greatly increased the ability of private investors to invest in fixed income and credit,” says UBS. “Through the use of the appropriate structured instruments, private investors can have credit exposure tailor-made to their needs, enjoy generally higher returns, and achieve a good level of diversification.”

4. Take into account the state of the credit cycle when making investment decisions

Just as there is a time to go defensive or turn aggressive in the equity market, conditions also change in the corporate bond market. When the investor expects a period of credit deterioration, due to economic downturn for example, they should consider a higher allocation to their investment grade vehicles.

As the credit cycle improves, they should adopt a move aggressive stance and shift assets from investment grade bonds to the high yield market. Again, this strategy may not be easily executed by the individual, so UBS suggests actively-managed corporate bond funds for the investor who does not have the required expertise.

5. Manage liquidity according to personal needs

While liquidity is usually considered the investor’s friend, it comes at a cost in the bond market, as more highly liquid securities trade at a premium to less frequently traded issues. If the investor is adopting a simple buy and hold strategy, collecting the coupon until maturity, then they probably should not pay the liquidity premium.

“The issue of liquidity is particularly crucial for credit products since many of them, such as CDOs, offer more attractive returns than corporate bonds with the same rating, but are less liquid,” the report says. “Such products should be borne in mind for inclusion in the less liquid part of an investment portfolio.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(10/27/05)

Steven Lamb