How to Construct Your Own Bond Portfolio

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How to Construct Your Own Bond Portfolio

Bonds have a place in many portfolios: safety, income, even capital appreciation. There are many types of bonds to choose from: US Government, municipals, corporate, even junk bonds. Here are some techniques you can utilize to construct your own bond portfolio:

Safety
If you buy short-term high quality bonds, or insured bonds, you have a very high degree of assurance that you will get your principal back, plus interest that is usually higher than on comparable CDs.

College education
Individual bonds are ideal when you need the money by a certain date: buy bonds that mature in the month(s) you will need the funds. No need to explain to your college-bound daughter why she now has to go to community college because “bonds fluctuate.” You will know exactly how much you will get.

Laddering
Interest rates are hard to predict. For that reason, you may want to ladder your portfolio: buy bonds that mature at regular intervals (6-12 months) so that you can reinvest the proceeds accordingly. Interest rates up >>> reinvest in longer maturities to lock in the yield; down >>> reinvest in shorter maturities to have cash available for when interest rates rise.

Capital appreciation
There are times when fear and panic depress bond prices, as happened in 2008. If you buy a $1,000 face value bond at a deep discount (less than the face value), you will realize a capital gain at maturity, in addition to the high annual interest you will lock in.

Monthly income

Most bonds pay interest semi-annually. But the payment dates vary. You can buy bonds that pay interest in January and July, February and August, and so on to create a fixed monthly income stream.

High current income

It’s best to buy bonds for safety first and income second. If you have a choice between an insured and an uninsured bond, go with the insured one, even if it means less interest. The only exception is junk bonds. Junk bonds pay high interest but have a much higher default rate. For that reason, you want to buy a junk bond fund – the only exception to our “no bond fund” stance. This way, you still get the high income but with less downside risk as typically any bond in a junk bond fund comprises less than 1% of the portfolio, so even a high profile bankruptcy like GM won’t hurt you much.

Tax-free
US Government bonds are free from state and local taxes. Municipal bonds are free from federal taxes and may be free from state taxes as well if you buy bonds issued by the state you live in.

Zero coupon bonds
don’t pay interest but are sold at a deep discount from their face value. As a bond nears maturity, it increases in value. At maturity, you get the full face value. The drawback of a zero coupon bond is that you have to pay annual taxes on “phantom” income (price appreciation) while you are holding it. For that reason, zero coupon bonds are ideal for tax-deferred accounts.

If you tweak and mix the above, you will have a well rounded diversified bond portfolio for a fraction of what a bond fund will charge you that is truly geared towards your specific needs/situation, with additional safety features built in.