You may think of bonds only as a way to earn income. Or maybe you turn to short-term CDs or money market funds for safety when the market is volatile. But fixed-income investments can also play an important role over the long term—they can help contribute return and reduce overall risk and volatility in a diversified portfolio. That's because their performance has tended to move in the opposite direction of stocks and fluctuated within a narrower range of highs and lows.
The fixed-income universe is broad. It includes debt instruments such as U.S. Treasury and government agency bonds, municipal bonds, corporate bonds, and certificates of deposit, with maturities that range from less than a year to 30 years or more. Fixed-income investments range from conservative to aggressive and you can buy individual securities or mutual funds that invest in them.
Given the range of choice, it's important to determine not only how much, but the types and maturities that are appropriate for your portfolio. Here's how.
What’s the right amount?
When you’ll need the money (your investing timeframe) and your tolerance for risk (the range of potential gains and losses due to volatility) are two key factors when determining how much fixed income makes sense for your portfolio.
Investors with shorter timeframes, such as those close to retirement, might not to be able to ride out a significant loss, and should consider a higher allocation to conservative fixed-income investments. Those with longer timeframes might be able to tolerate more volatility and could consider a more aggressive mix of stocks and fixed-income investments. Each approach has a tradeoff. When you choose greater security of principal and lower overall volatility, your investments may not grow enough to keep up with rising costs. If you choose the potential for higher returns, there is also the potential to lose more money.
That said, our six target asset mixes can give you a sense of how much fixed income may be appropriate for your portfolio. They show how asset mixes can be created with different risk and return characteristics to help meet an investor's goals. You should choose your own investments based on your particular objectives and situation.
Once you determine how much of your portfolio to allocate to fixed income, you need to choose types. Your time frame and risk tolerance also come in to play when choosing specific investments. In general, the lower the risk, the lower the yield and potential for returns. The chart below shows the range of choices along a risk spectrum. Past performance is no guarantee of future results.
Shorter term, lower risk
If you're looking for an investment that typically doesn’t vary much in price and value, and the risk of default or loss is extremely low, consider money market mutual funds, short-term FDIC-insured certificates of deposit (CDs), or U.S. Treasury bills that mature in a year or less. Securities issued by the U.S. Treasury are backed by the U.S. government. CDs issued by FDIC-insured institutions and are generally insured up to $250,000.1 The tradeoff with these investments is that in exchange for safety they tend to produce less return. Therefore, investors need to consider the eroding value of inflation, as well as the opportunity cost of not investing in other instruments that may be more risky but might offer higher yields.
In the middle: Investment grade
Investment-grade bonds, which include U.S. government and government agency bonds, certain U.S. corporate bonds, many municipal bonds, and debt of developed foreign governments such as Germany and the United Kingdom, are next on the risk spectrum. These bonds are rated by credit-rating agencies (such as Standard and Poor's, Moody's, and Fitch Ratings) in large part on the issuer's ability to make income and principal payments to debt-holders. Those best prepared to do so are rated investment-grade (BBB and higher), while the debt of those organizations with a higher risk of default is rated non-investment-grade (BB and lower.)
Some investment-grade bonds are tax-exempt. Also known as municipals or munis, they typically consist of debt issued by cities or towns, state governments, or agencies and certain not-for-profit institutions. The interest income earned from these bonds is generally not subject to federal taxes and sometimes is also exempt from state and local taxes. Some bonds are also free of exposure to the federal alternative minimum tax (AMT). There are also taxable municipal bonds, including Build America Bonds where the Federal government is subsidizing a portion of the borrowing costs.
Higher yield, higher risk
Non-investment-grade bonds, also known as high-yield bonds, generally have higher interest rates in order to compensate for their greater potential risk. Distressed companies and highly leveraged companies tend to struggle more than better-capitalized companies during economic downturns. Investors should be prepared for higher levels of volatility and the increased risk of default in exchange for the potential to deliver attractive returns at certain points in the economic cycle. Also, given the inherent credit risk associated with individual high yield bonds, it is very important to diversify across many different issuers from different industries. For the average investor, the best way to achieve this may be through a more diversified vehicle like a mutual fund.
Individual securities or mutual funds?
Once you’ve identified the appropriate amount and type of fixed-income investments for your portfolio, you need to choose between individual securities or mutual funds. Some investors own both. In general, individual bonds may make sense if you have time to monitor and research your investments and to diversify across individual issuers and bonds. Individual government-backed or investment-grade bonds may be appropriate if you need a set interest payment or return of a fixed principal amount. You can create a combination or "ladder" of individual bonds with different maturities and income payment schedules to meet your income needs, investment time frame, and comfort with risk.
On the other hand, mutual funds typically spread their holdings across hundreds of issuers or individual bonds analyzed by bond-market and legal experts using data and tools not usually available to individual investors. While bond mutual funds typically pay income on a predictable schedule, the amount of income in each distribution may vary, as they invest and reinvest assets in bonds with different maturities.
As you can see, there's a place for fixed-income investments in just about everyone’s portfolio. The key is to make sure you have not only the appropriate amount, but the appropriate type. The tools listed below can help you do just that.
Before investing, consider the funds’ investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.