How to Build Your Own Bond Portfolio
When creating a portfolio, look at credit ratings, yield, cost-comparisons and more.
A portfolio of individual bonds holds some attractions for hands-on investors. With high-quality corporate bonds, you know in all likelihood that you can collect your coupon payments and get your principal back when the bond matures. Bond mutual funds, which generally don’t have preset income payments or maturity dates, don’t offer such assurance.
“When you buy individual bonds, you can focus on structuring a set of cash flows that meets your needs,” says Stan Richelson, co-founder of the Scarsdale Investment Group, an investment adviser that builds individual bond portfolios. Investing in a fund also boosts the risk that human behavior will muck up your returns. When markets tumble, spooked investors may withdraw assets in droves, which can force managers to sell perfectly good bonds in a down market. Bond managers can inadvertently sabotage their funds, too, by trying to juice returns by adding risky debt.
But buying individual corporate bonds comes with plenty of pitfalls, too. Many investors believe that they can eliminate the risk of rising interest rates by buying individual bonds and holding them to maturity. But if you buy a bond and rates rise, the market price of your bond falls—and you could lose money if you need to sell before maturity. Even if you hold until maturity, you’ve purchased a stream of income at a relatively low interest rate. As rates rise, that same stream of income becomes available at a lower price, and you miss out on an opportunity to buy higher-yielding bonds.
In a bond fund, meanwhile, investors may see an initial price decline when rates rise, but the fund will typically generate higher income as it invests in bonds with higher yields.
Investors buying individual bonds may also encounter hefty transaction costs—and a load of homework. “It’s a lot more work than plopping your money into a mutual fund,” says Marilyn Cohen, chief executive officer of Envision Capital Management, an investment adviser specializing in bond portfolios. Cohen says that a well-diversified portfolio should include bonds from 20 to 25 different issuers, spread across different industries. That’s a lot of companies to research, plus you can’t simply set-and-forget that portfolio. Although the default rate among investment-grade corporate bonds is very low—in the past 35 years, an average of only 0.1% have defaulted annually, according to S&P Global Ratings—that’s in part because issuers are typically downgraded to junk status before they default. So you’ll have to check in on your issuers’ credit ratings and financial health as part of your regular portfolio upkeep.
A Step-By-Step Guide
Here’s how you can build your own bond portfolio:
Log on to your online brokerage account and click into bond offerings to see a list or matrix of available corporate bonds. Unlike stocks, bonds don’t trade on exchanges, so what you see doesn’t represent every corporate bond in existence. Instead, depending on your broker’s system, you’ll likely see a list of current offers from bond dealers or alternative trading systems (which function as unofficial exchanges by matching buyers with sellers), along with perhaps a few bonds that your broker owns as inventory. For corporate bonds, you’ll overwhelmingly see secondary market offerings, rather than new issues. “New-issue corporate bonds are not very individual-investor friendly,” says Chad Jones, vice president of fixed income and insurance services for Charles Schwab. That’s because investment banks, which mainly cater to institutional investors, act as gatekeepers for new issues.
Once you focus on a set of specific bonds, you’ll be confronted with a table of numbers. Let’s parse the gibberish. Corporate bonds typically pay interest semiannually and have a $1,000 face value. So if you see a bond listed with a 7% coupon, it probably pays $35 twice a year. The maturity date is the day on which owners will receive their $1,000 in principal back. The bond’s price is expressed as a percentage of its principal value, so a price listed as 110 translates to $1,100 per bond (because interest rates are so low, almost all bonds are now trading for more than $1,000). The minimum and maximum quantities indicate how many bonds are available at that price. And the listed credit rating expresses an assessment of the issuer’s financial health and ability to meet its obligations. Stick with bonds that carry a rating between AAA, the top rating, and BBB, the lowest rating for investment-grade bonds.
Of course, what you’re really interested in is the bond’s yield. Yield-to-maturity represents the total return you’ll earn over the life of the bond, after taking into account the purchase price and all the coupon payments you’ll receive. But yield conveys more than just your return. “You should look at yield almost as a measurement of risk,” says Richard Carter, vice president of fixed income products for Fidelity. If a bond has a notably higher yield than similar bonds, don’t assume you’ve unearthed a gem. Rather, that higher yield may signal that the market is “reflecting some danger” for that particular bond or issuer, Carter says.
You might also see a yield-to-worst figure listed. This is only relevant for bonds issued with certain bells or whistles, such as call options, which give the issuer the option of redeeming bonds early (this is more of a concern in a falling-rate environment, when companies may decide to refinance old debts at lower rates). The yield-to-worst figure represents the lowest possible yield you might earn on that particular bond, short of the issuer defaulting, if the issuer were to exercise or not exercise some of those bells and whistles.
Also, do the type of sleuthing you’d do before buying a stock, such as reading a few annual reports and earnings releases, and looking into the company’s financial ratios. Cohen advises you also look out for certain warning signs: share repurchase programs or large acquisitions funded with debt. Those are “flaming red flags,” she says, because they likely indicate that management is not prioritizing the company’s financial health.
Your final step: cost-comparison research. Check prices on recent trades of a specific bond by looking up the bond’s CUSIP number at finra-markets.morningstar.com. The larger the purchase amount, typically the better the available price. If you have multiple brokerage accounts, try comparing prices on the same bond. Most online brokers add their own in-house markup. If you’re not sure about the price on offer, use a limit order.
When structuring your portfolio, consider building a bond ladder. Set up the portfolio so that bonds mature at regular intervals, such as every year. You’ll regularly receive principal payments to reinvest at potentially higher rates.