How to Construct Your Fixed-Income Portfolio

Both Treasuries and TIPS are simple to access and to understand and can reasonably account for a large chunk of the portfolio.

From here, the allocations get much smaller.

Stressing the Individual

Also, as with equity investing, foreign exposure can provide good diversification, especially if the dollar declines. Individual issues are difficult to access, but there are plenty of closed-end funds to choose from, as I wrote about in February. Most clients own the Aberdeen Asia Pacific Income Fund (FAX Quote) at a 10% fixed-income portfolio weight. I find that 10% provides a little bit of a hedge without making an extreme bet. The vast majority of the time, you are unlikely to see the effect of foreign diversification, and that is just fine.

For corporate exposure, I favor preferred stocks. Most of them are easily traded on the NYSE, are fairly liquid and do not require large dollar amounts to participate. Typically, I allocate 15% of the fixed-income portfolio by owning three different issues at 5% each. I prefer individual issues to funds because at times of interest rate volatility, the funds seem to get hit worse than the individual issues.

Also, investors have more control of credit quality and maturity by selecting individual issues. Realistically, there is little risk buying a preferred stock from an AA or higher-rated company. For investors who are not comfortable selecting preferreds on their own, the PowerShares Financial Preferred Portfolio (PGF Quote) might make for some good middle ground between individual issues and an actively managed fund.

I am a big believer in convertible bonds. They can offer higher yields and be a little less interest-rate sensitive than other market segments. Here again, individual issues can be difficult to access, and there can be more issuer risk than in other segments, so a fund makes sense. I prefer the Advent Claymore Convertible Securities & Income Fund (AVK Quote), which is a closed-end fund. Converts can be volatile, and while I generally allocate 10% to this segment, some folks should use less than this or avoid it altogether.