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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). 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.

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) 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) 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), 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.

The last 10% of the fixed-income portfolio can be sort of a catchall that depends more on individual tolerance than anything else. I will usually allocate the final 10% to one of the closed-end funds that owns equities and sells covered calls. I first wrote about these a year and half ago and have maintained exposure even longer. While it is crucial to realize these funds own equities, they behave like bond funds the vast majority of the time. I believe they can be less interest-rate sensitive at times when rates go up a lot.

You will notice that there was no high-yield or emerging-market exposure here. For now, interest rate spreads do not favor these parts of the market, but it makes sense to expect that both segments will become attractive at some point and will merit some exposure in the future.

To reiterate -- this is not the best way, it is one way. The mix generally does what I want it to do, but there are many ways to build a fixed-income portfolio. I hope that this will help some people start to think about it if they have not done so already.

At the time of publication, Nusbaum was long Aberdeen Asia Pacific Income Fund and Advent Claymore Convertible Securities & Income Fund, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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