The message to diversify investor portfolios is so routine that its importance may be desensitized to an investor, or worse, disregarded. It’s like ignoring the warning label attached to a prescription drug. The underlying message is important but easy to overlook. That is, until it’s too late.
Diversification can take many forms: by obligor, by sector, geographically, by coupon, by maturity, etc. The idea of not putting too many eggs in one basket carries merit. Let’s look for example, at diversifying by obligor.
The chart on the right provides a simple comparative illustration of 2 portfolios side-by-side and the effects of obligor diversification. The first uses 20 issuers to create a 10 year laddered portfolio while the second uses 10 issuers. Should 1 issuer default ($25,000 in the diversified portfolio and $50,000 in the other), the downside to the 10 issuer portfolio can be greater than the difference in the size of the holding due to not only the loss of principal (assumes a 0% recovery rate and constant reinvestment), but the forward loss of interest earned on that principal. In this example, $25,000 in principal plus the lost compounding interest reflects an aggregate difference of -$32,119. Diversification cannot guarantee anything but increases the probability of mitigating negative consequences.
The same principle applies to other forms of diversification, such as diversifying geographically. Should some catastrophic event occur in a specific state, county or local region, you do not want all of the portfolio’s debt tied to that location. By the same rationale, bonds should not be tied to one industry such as all energy.
The concept is not complex but because it can be unintentionally snubbed, a reminder to the importance and mindful implementation of diversification can mitigate portfolio risk without necessarily impacting the overall portfolio strategy.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.