Constructing a Bond Portfolio?

By now, you must have identified me as a equity-bull and I continue to believe they’re the best income investment around for this year. However, to those pessimists out there, I propose a bond portfolio to diversify income and risk. The problem right now is that interest rates are pitifully low, particularly on the long end of the yield curve and risk involved with many of the higher-yielding bond categories is still very high. The 3-year MGS benchmark is currently hovering below 2.7% and it seems that market consensus is even expecting a 75 basis point cut!

This leaves us with not much options and I suggest you to largely steer clear of longer term government securities as well as high risk corporate right now. Someday in the near future, however, I think we are going to see longer term government papers yields to rocket higher, as pressure on US deficit and Treasury financing can be deadly inflationary. And then, it is not too late a time to consider starting to snap them up. Corporate bond activities continued to be sparse as liquidity thinned in early part of this year and investors continue to lap up high-grade credits, especially those with some form of government backing.

At this point in time, let us consider laddering the bond portfolio with a heavy bias towards the shorter rungs. Laddering is a good technique to hedge your bond portfolio against any sudden change in interest rates. Investing in bonds with various maturities and as they mature, re-invest the proceeds into new bonds at the highest rung of the latter. This allows some free-cash flows to work at current rates while protecting other portions of the portfolio. So, if the rates are falling, you will have some of your long-dated bonds would be in-money.

Of course this method will not allow you to get big return for the risk and another option is eschewing bond altogether and using mutual funds or exchange traded funds instead. This method will take out the benefits of laddering, but it gives a good diversification both in length and types of bonds held.

The idea is simply to keep the money spread out so that a move in rates doesn’t leave you high and dry and make sure that you are more weighted towards the short-end of the maturity range.