Maintain a Healthy Investment Diet B y Including Bonds in Your Portfolio

Just as eating a wide variety of foods is necessary for sustaining a healthy body, selecting an assortment of investments is necessary for maintaining a sound fixed-income portfolio. But how do you choose the right bonds when there are so many? The U.S. bond market is, after all, the world’s largest financial market.1 The key is to hold a diversified portfolio, based on your goals, risk tolerance and time horizon.

The Three Basic Bond Groups
Different bond investments may serve different purposes. For example, because U.S. government bonds are backed by the full faith and credit of the U.S. government, they entail minimal credit risk (the risk that the issuer may default on the debt). These securities generally appeal to investors seeking steady income and solid protection of principal. But in exchange for less risk, they usually offer lower yields.

Corporate bonds, on the other hand, carry different levels of credit risk. For instance, high-yield corporate bonds are considered more of a credit risk than higher-rated investment-grade bonds. High-yield bonds are issued by companies with short track records or firms that are experiencing problems but may have long-term potential. Given the higher risk level involved, they may offer higher yields. Investment-grade corporate bonds, on the other hand, may offer less risk in exchange for lower yields.

Municipal bonds are bonds issued by state governments and municipalities. They may provide income that is exempt from federal (and sometimes state and local) income taxes.2 Because of their potential benefits when compared with taxable securities, municipal bonds may be appropriate for investors in higher tax brackets. The risk associated with a municipal bond depends on the credit rating of the issuing government agency.

Fortifying Your Portfolio
When investing in bonds, consider the following ideas:

• Diversify: Hold a mix of bond investments to potentially reduce risk. If a corporate bond investment declines in value, for example, a government bond investment may increase in value and potentially help compensate. There are other bond diversification strategies to consider as well. A “barbell” strategy involves holding bonds with both short- and long-term maturities. And “laddering” requires holding bonds with average maturities all along the maturity spectrum.
• Matching maturities: Match your investment time frame to the maturity of your investments. For example, if you want to withdraw interest plus $10,000 in principal from your portfolio each year to meet living expenses, buy bonds with maturities of one, two and three years in $10,000 increments.
• Bond mutual funds: By investing in a collection of bonds, a bond mutual fund offers the benefit of diversification. In addition, professional management of bond funds can save you the hassle of having to research the thousands of individual bonds on the market, and lower initial investment requirements help ease accessibility to a wide variety of bonds.

Check with a qualified financial professional to make sure your bond portfolio contains the correct fixed-income investments for your financial profile.

1Source: The Bond Market Association, 2003.
2Income may be subject to the federal alternative minimum tax. Capital gains, if any, are subject to taxes.

©2004 Standard & Poor’s Financial Communications. All rights reserved.