Why should I diversify my fixed income investments?

Diversification is a basic investing principle that can help maximize returns and reduce volatility. Many investors own a mix of asset classes (e.g., stocks and bonds) but aren’t diversified within these asset classes, particularly within fixed income.

Let’s look at why it’s important to own a diversified range of different fixed income securities.


Investing Across Fixed Income Sectors

Although you are probably aware that stock and bond returns differ dramatically, you may be less aware that different types of fixed income investments have provided widely varying year-to-year returns.

The chart below ranks key fixed income sectors by total returns for each year from 2004 to 2013.

FIXED INCOME RETURNS VARY DRAMATICALLY

As the chart shows:

In 2011, Treasuries was one of the best performing sectors, up almost 10%.

In 2004, however, Treasuries was one of the worst performers, with a return of about 3.5%.

Looking at U.S. Treasuries across all 10 years, it’s clear the sector has been on a wild ride. It was one of the worst performers in 2004 before having fair returns in 2005. It was worst in 2006, then the leader in 2007 and 2008, but fell behind again in 2009 and 2010. As we noted, in 2011, US Treasuries were once again a top performer, but the very next year they plunged to the bottom.

Because it’s impossible to predict with any certainty which sector will “win” in any given year, it’s important to diversify your investments across sectors. But even the Aggregate, which is focused on investment-grade securities and based on the Barclays US Aggregate Bond Index, may not be the best choice. While the Aggregate was never one of the bottom two sectors, it was in the top two only once, indicating a potential opportunity for superior returns by diversifying into additional sectors.


Correlations Between Fixed Income Sectors

It’s likely that you’ve diversified your portfolio across asset classes like stocks and bonds in part because their correlations are low — meaning they tend not to move in the same direction at the same time. But have you diversified your fixed income portfolio to take advantage of lower correlated sectors of the market?

The chart below shows a matrix of fixed income correlations for the 10-year period from 2004 to 2013.

FIXED INCOME SECTORS OFTEN HAVE LOW CORRELATION

As the chart shows:

Just as you would expect, the returns of most fixed income sectors have historically shown low or even negative correlations to the returns of the stock market.

Perhaps less expected, the returns of many fixed income sectors have had low or negative correlations to other fixed income sectors. This means that combining different fixed income sectors in a diversified portfolio may help decrease overall portfolio risk.

Investing involves risk, including possible loss of principal.

Diversification and asset allocation may not protect against market risk or loss principal.

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