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Diversification Isn’t (Necessarily) Necessary for Fixed Income

A reader writes in, asking:

“What are your thoughts on bond diversification? Is it ok to just do something simple like a treasury bond ladder or is it necessary to diversify bonds like you do with stocks?”

No, I really don’t think that diversification is necessary for the bond portion of an investment portfolio.

Several years ago, prior to switching to a LifeStrategy fund, the bond portion of my portfolio included nothing but Treasury bonds (via a single bond fund). And that didn’t bother me at all.

The goal for the bond part of my portfolio was (and still is, for the most part) simply to act as something that is unlikely to go down (by much) during a stock market downturn. CDs or Treasury bonds (regardless of whether or not they’re held in a mutual fund, and provided they aren’t long-term bonds) achieve that goal very well without any need for additional fixed income holdings.

When Diversification *Is* Necessary for Fixed Income

Just to be clear on this point, when it comes to fixed-income investments other than FDIC-insured CDs and Treasury bonds, diversification is important. That is, if you’re putting a significant part of your portfolio into muni bonds, corporate bonds, or international bonds, yes, you definitely want to diversify those holdings.

Diversification Isn’t a Bad Idea

For many investors though, the goal of their bond holdings isn’t only to act as “something safe.” They also hope to achieve some degree of “free lunch” via diversification. The general thought process is that if something has a low enough correlation to the rest of your portfolio while providing an acceptable return, adding it to the portfolio can result in reduced risk without a correspondingly large reduction in return.

This is the argument, for instance, that Vanguard makes in favor of international bonds in their funds-of-funds.

That’s a thoroughly reasonable line of thinking. And if things go according to plan (i.e., correlations and returns behave the way you hope they will) it will improve your results.

However, it isn’t necessary. And it’s not entirely obvious that it’s a clear improvement over an all-CD or all-Treasuries fixed income portfolio, because:

  • CDs offer their own sort of free lunch sometimes, if you can find longer-term CDs (that have relatively high yields due to the long term) with low penalties for early redemption, and
  • Corporate bonds (i.e., the most likely candidate for adding to an otherwise-Treasury bond portfolio as a diversifier) often have higher correlation to stocks than Treasury bonds do, so it’s not a sure bet that they will have the desired result.

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