How to Construct Your Fixed-Income Portfolio

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Lately, several readers have asked about fixed-income portfolio construction. The nuts and bolts of this do not get discussed very often, and while I don't have all the answers by any means, a look over my shoulder might be worthwhile for some folks.

As with equity investing, it makes sense to capture different segments of the market and be willing to use different tools to get the job done.

Reducing Volatility, Adding Yield

Most people think about owning bonds for the income, and this is valid, but fixed-income instruments can also reduce volatility and add a little yield to the overall portfolio, even if there is no intention of taking income out. This could reduce returns somewhat, but it also reduces volatility, and that will appeal to some investors.

Usually the heaviest weighting will go to U.S. Treasuries -- roughly 35% of the fixed-income portion of the portfolio. For now, with the yield curve somewhere between flat and inverted, it makes sense to keep maturities short. I think the likelihood that the yield curve normalizes in the next year or two, pushing intermediate rates up to something closer to the historical norm, is very high. I would rather lock in 4.9% for a year for the chance to earn more on a five-year Treasury note 12 or 18 months from now.

However, funds or ETFs that buy Treasuries would not be my first choice, because Treasuries are very liquid and can be purchased in small amounts, and there is no reasonable issuer risk taken in this market.

For clients for whom municipal bonds are appropriate, I would own them, again preferably individual issues, in lieu of Treasuries.

Some Inside TIPS

The second-largest allocation -- 20% -- within the fixed-income portfolio is the inflation-protected segment, where I prefer the iShares Lehman TIPS Bond ETF (TIP Quote). Choosing an ETF instead of individual issues is debatable, but I find ETFs easier to access, and given the low yields in this segment, I believe that capturing most of the effect in a similar manner is best for those who are not taking income.