AUGUST 2017

Diversifying Your Bond Portfolio

M ost investors understandthe benefit of diversifyingtheir stock portfolios: it’s a

matter of spreading your risk. Butdoes the same principle apply to abond portfolio? The simple answeris yes.

Bonds carry risk. As an assetclass, bonds pose less risk thanstocks for the simple reason that ifand when an issuer goes out ofbusiness, bondholders take prece-dence over stockholders when itcomes to distributing assets.

Here, we’re talking about creditrisk — just one of the several differ-ent kinds of risk bond investorsface. It’s impossible to eliminate thisrisk entirely from any bond portfo-lio: companies go out of businessand pay bondholders pennies onthe dollar, and governments — evensovereign national governments —can run into financial trouble and

pay out later than scheduled orrenegotiate their debt on terms thatare less favorable to investors.

U.S. Treasuries’ Safety Comes at a Cost

When it comes to credit risk, the outlier is U.S. Treasuries: Treasury bills, bonds, and notes.Backed by what is still regarded asthe strongest, most stable govern-ment in the world, U.S. Treasurysecurities are considered the safestchoice for receipt of timely interest

Consider Maturity Dates

B efore deciding on a maturity date, review how that date affectsinvestment risk and your ability to pursue your investment goals.

Investors are often tempted to purchase bonds with long maturity datesto lock in higher yields, but that strategy should be used with care. Twofundamental concepts about bond investing apply:

4 Interest rates and bond prices move in opposite directions. Abond’s price rises when interest rates fall and declines when interest

rates rise. The existing bond’s price must change to provide the sameyield to maturity as an equivalent, newly issued bond.

4Bonds with longer maturities are more significantly affected byinterest rate changes. Since long-term bonds have a longer stream

of interest payments that don’t match current interest rates, the bond’sprice must change more to compensate for the interest rate change.

Although you can’t control interest rate changes, you can limit theeffects of those changes by selecting bonds with maturity dates close towhen you’ll need your principal. Please call if you’d like to discuss bondmaturities in more detail. mmm

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U C C E S S

payments and full redemption. So,Treasuries remain bond investors’best choice for minimizing thechances that they won’t receiveredemptions at the bonds’ facevalue.

But because Treasuries are thesafest bonds out there, they comewith a downside: across the maturi-ty spectrum, the interest rates Trea-sury securities pay are among thelowest you’ll find. In other words,you trade income for safety — and

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Copyright © 2017. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. Thisnewsletter intends to offer factual and up-to-date information on the subjects discussed but should not be regarded as a complete analysis ofthese subjects. Professional advisers should be consulted before implementing any options presented. No party assumes liability for any lossor damage resulting from errors or omissions or reliance on or use of this material.

Private Wealth Management200 Public Square, Suite 1650Cleveland, OH 44114Toll-free (888) 792-9821Fax (216) 737-7370www.rwbaird.com

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John KraftSenior Vice PresidentFinancial Advisor216-737-7337jkraft@rwbaird.comwww.bairdfinancialadvisor.com/kraft

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not having the income you need tomeet your goals has to be consid-ered a risk.

So why diversify away fromTreasury bonds? Not to control riskbetter, but to achieve higher income.And that’s the principal reason fordiversifying your bond portfolio: toachieve a better balance betweenrisk and reward to match yourneeds and objectives.

There are basically three dimen-sions of bond diversification: issuer,credit quality, and maturity.

Different Issuers, Different Risks and Rewards

There are five major sectors of the bond market, and they’redefined by the class of issuer. Eachposes a different risk/reward pro-file. As in all financial markets, thelower risk you want, the lower your potential rate of return; to get ahigher level of return, you must takeon more risk. In ascending order ofreward, the sectors are:

4U.S. Treasuries. Backed by thefederal government’s authority

to print money and the U.S. econo-my’s long-term history of moderateto low inflation, Treasuries offer

DiversifyingContinued from page 1

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the highest level of safety and thelowest yield.

4 Federal agency bonds. Theseinclude bonds issued by mort-

gage agencies backed by the federalgovernment, including Ginnie Mae,Fannie Mae, and Freddie Mac. His-torically, these bonds pay higheryields than same-maturity Trea-suries, since none of these agenciesare backed by the full faith andcredit of the U.S. Treasury. (Whilethe federal government did bail outbondholders in 2008 following thecollapse of the mortgage-backedbond market, there is no guaranteethat in the future the same thingwill happen.)

4Municipal bonds. These areissued by nonfederal govern-

ments and agencies. Because theyhave the legal power to tax orcharge fees, as an asset sub-classthey are regarded as second to Trea-suries in safety. As a result, they canpay a higher after-tax rate of returnthan other types of bonds. Becausethe income they generate is usuallyexempt from federal and sometimesstate and local income taxes,investors in higher tax brackets canearn higher after-tax income thanthey can from other types of bonds.

4Corporate bonds. These actu-ally fall into two categories:

investment-grade or high-qualitycorporate bonds and high-yield

corporate bonds, also known asjunk bonds. Corporate bonds offerhigher yields than Treasuries ormunicipal bonds; but because theirissuers are business enterprises,they present more risk. Junk bondsoffer the highest yields but areissued by companies in financialdistress — those that pose a greaterrisk of going out of business beforethe bonds mature.

4 Foreign bonds. This is really asprawling category of issuers,

since it includes national govern-ments and corporations and coun-tries in both the developed worldand emerging markets. The com-mon additional risk element acrossall of these subcategories is curren-cy risk — the possibility the valueof the foreign currencies will fallagainst the dollar, reducing the rela-tive value of the bond.

Riskier Credit and LongerMaturities Mean HigherYields

The lower you go in credit rat-ings and the longer you go out inmaturity, the higher the interestrates you’ll find. That’s becausethere are greater risks that an issuerwon’t be able to make its payments,or inflation and interest rates will behigher and bondholders will bestuck with below-market yields.

The purpose of diversificationin both stocks and bonds is to fine-tune the trade-offs investors makebetween risk and reward potential.With interest rates near historiclows, many bond investors havebeen tempted to reach for higheryield by taking on more risk in theform of lower-rated issuers andlonger maturities.

With literally thousands of dif-ferent bonds in the market, it’s asignificant task to find the best mix of issuer, credit, and maturity.Please call if you’d like to set up aportfolio review. mmm

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time you deposited $10, would youaccept that? That’s what manycompanies offer through their401(k) matching programs. Yet,surprisingly, many people don’tparticipate.

Simply put, in almost everycase, not participating in your com-pany’s 401(k) matching programdoes not make sense. Figure outhow to budget your monthly take-home pay so that you can con-tribute at least as much as youremployer will match (most match50 cents or $1 for every $1 contribu-tion, up to a certain percentage ofthe employee’s salary).

5. Suffering AnalysisParalysis

Is your retirement fastapproaching and the anxiety hasyou avoiding the details? Are youjust out of college and feel asthough you have a lifetime to accu-mulate enough for retirement?Whatever your situation, it is betterto be prepared for retirement thannot. The mistake here is either fail-ing to tap the benefits a 401(k) planoffers (like company matching) orsetting up contributions and thenfailing to pay attention to how theyare allocated and making necessaryadjustments.

If you feel like you may bemaking some of these mistakes orwould simply like help preparingyour investments for retirement,please call. mmm

Avoid These 5 401(k) Plan Mistakes

A popular retirement vehicle inthe United States, 401(k)plans bring millions of peo-

ple closer to their dream retirement.While it’s true that participation isthe first step, simply putting moneyinto a 401(k) plan won’t guarantee acomfortable retirement. All too fre-quently, people make mistakes withtheir 401(k) plans that cost themmore than they realize, sometimespreventing an early or on-timeretirement. Consider these fivecommon 401(k) mistakes and howyou can avoid them:

1. Believing Simply Contributing to Your401(k) Plan Is Sufficient

Again and again, people believethat spending carelessly is okay aslong as they are also contributing totheir retirement fund. Not true.Simply contributing to your 401(k)plan does not necessarily mean thatyou are going to have a comfortableretirement.

Your goal should be to con-tribute the maximum annual limit— $18,000 for people under 50 yearsof age and $24,000 for investors 50years of age or older. Contributingat that level clearly isn’t realistic foreveryone, and certainly some levelof contribution is better than noth-ing. But living well within yourmeans today — taking control ofyour spending so you have someleft over at the end of the month tosock away in a retirement fund —can mean a more comfortable retire-ment tomorrow.

2. Using Your 401(k) Planas a Savings Account

When you go through a majorlife event, such as a job change, thebirth of a child, sending kids to col-lege, or a divorce, it can be tempt-ing to cash out your 401(k) plan toget you through that rough patch.Indeed, the lure of the now can bedifficult to resist, but the point of a

401(k) plan is to give yourself acomfortable tomorrow.

Withdrawing from your 401(k)plan today not only puts a dent inthe balance that will compoundover time, but if you’re not yet atretirement age, the Internal RevenueService may send you a hefty taxbill for withdrawing that retirementmoney early.

Here’s an example. If at age 25you cash out a 401(k) plan with abalance of $5,000, you wouldreceive around $3,100, $5,000 minus28% ordinary income tax ($1,400)and the 10% early withdrawalpenalty ($500). However, if you keptthat $5,000 invested until age 65(assuming 8% annualized earnings),you could end up with more than$108,000 at retirement. (This exampleis provided for illustrative purposesonly and is not intended to project theperformance of a specific investmentvehicle.)

To the extent that you can, leaveyour 401(k) alone to grow until yourretirement. Use other cash assetsfor those inevitable rainy days.

3. Fearing DiversificationDiversification is a risk -

management technique that mixes a wide variety of investments with-in a portfolio. It’s based on the ideathat a mix of different investmentsmay yield higher returns with lowerrisk than any individual investment.

A good rule of thumb is toinvest more in equities the furtheryou are from retirement, and thengradually increase your bond allo-cation over time to help make thatshift from a growth orientationtoward an income orientation. Thepoint is this: a blend of investmentsis important and requires adjust-ments along the way.

4. Not Participating in aCompany Match Program

If your bank gave you $10 every

A Look atBond Tents

Financial Thoughts

Incorporating Bonds into Your Portfolio

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A n important retirement strategyto consider is building a bond

tent. This strategy increases the allo-cation of bonds during the 10 yearsor so prior to retirement, and thenthe bonds are sold from this portionof your portfolio during the first 10to 15 years of retirement, providingyou with an income stream.

The reason this strategy iscalled a bond tent is that if you lookat it on a line graph, the bonds inthe portfolio steadily rise until theyreach a peak at retirement and thenfall as the bonds are sold, whichmakes a tent shape.

The strategy works by reallocat-ing a traditional 60/40 mix of stocksand bonds to an allocation of 50% or60% in bonds by the time you retire.

The bond holdings are then soldduring the first half of retirementuntil the original mix is once againreached. This provides portfolioprotection against major losses dueto market downturns during thefirst half of retirement. The portionof your portfolio that is still instocks will continue on the path forlong-term growth to fund your lateryears of retirement as well as pro-vide protection against inflation.mmm

B y taking the time to considercertain specifics about bondinvesting, you can determine

the appropriate way to includebonds in your portfolio.

Identify your investmentgoals. An investor focused on long-term growth and capital apprecia-tion with no need for currentincome will have less of a need forbonds. On the other hand, aninvestor looking for a balance ofincome and capital appreciationwill have more bonds in his/herportfolio. An investor primarilyinterested in interest income willhave a significant portion of his/herportfolio devoted to bonds.

Know your investment timeframe. As you select bonds foryour portfolio, consider when youwill need the principal. Investorsoften purchase bonds with longmaturity dates, because the yield onbonds tends to increase as maturitydates lengthen. However, if youpurchase a long-term bond and sellit before maturity, interest ratechanges can significantly affect thebond’s market value.

Determine your risk tolerance.Typically, the higher a bond’sreturn, the greater its risk. Thus,U.S. Treasury securities, which areconsidered one of the safest bonds,

typically carry lower interest ratesthan municipal or corporate bonds.

Understand the tax ramifica-tions. Different types of bonds aretaxed differently. Interest incomefrom U.S. Treasury securities isexempt from state and local incometaxes but is subject to federalincome taxes. Interest income frommunicipal bonds is exempt fromfederal income taxes and typicallystate and local income taxes for residents in the issuing state. Inter-est income from corporate bonds is subject to federal and state incometaxes. Investors in higher marginaltax brackets typically find taxexemption of interest income morevaluable. Any exemption fromincome taxes applies only to interestincome, so capital gains from thesale of a bond are still subject toincome taxes.

Consider specific bond variables. Before you purchase aspecific bond, make sure you fullyunderstand its features, includingmaturity date, credit rating, call provisions, coupon rate, yield tomaturity, price, and tax ramifica-tions of interest income.

Please call if you’d like helpevaluating bonds for your portfolio.mmm

W omen face five challengeswhen ensuring they have

enough income for retirement. 1. Fewer working years: Women

average just 29 years in theworkforce compared to 38years for men. The difference isdue to time taken off to carefor children and, to a lesserextent, elderly parents.

2. Lower pay: Professionalwomen earn 28% less than professional men.

3. Greater risk aversion: Womentend to maintain higher cashallocations and lower stockand mutual fund allocationsthan men do.

4. Longer lifespans: Women age65 outlive men of a similar ageby 2.5 years. In situationswhere the wife outlives herhusband, women live an addi-tional 11.5 years following thedeath of their spouses.

5. Health care costs are higher:

Women will spend $19,558annually on health care oncethey turn 65, compared to$18,251 for men (Source: TIAA,October 2016).Approximately 25% of par-

ents have taken on debt to sup-port adult children, and 60% ofparents would keep workinglonger to support adult children(Source: Money, January/February2017). mmm­­