Should You Invest in Debt Securities?

Debt securities play multiple roles in an investment portfolio.

Depending on your investment strategy, there are several ways you can position your bond investments for steady income, capital preservation or appreciation.

A bond is a contractual agreement in which an entity borrows money and promises to repay you interest on your money and the principal back at the end of the bond term or its maturity date. The debt can be structured for the short term or long term, depending on when you prefer to get your money back. Bonds can also pay interest for a set period, such as every six months, quarterly or annually.

Your approach to bond investing has to start with knowing the security’s fundamental characteristics to understand how to position them in your portfolio. Keep these points in mind:

— Debt security characteristics.

— How to diversify your debt securities.

— How to enhance fixed-income returns.

[See: Best Fixed-Income Funds to Buy]

Debt Security Characteristics

Knowing the risks associated with bonds is integral to shaping your portfolio.

To know how much risk you’re taking, investors should look to the bond’s maturity risk and credit risk, two components that drive your investment returns on bonds.

In an ordinary market environment, the longer it takes your bond to reach maturity, the higher the expected return from the investment. Likewise, the lower the credit quality of the entity, otherwise known as the ability for it to repay the debt, the more income you may generate.

“Longer maturities typically incorporate more unknowns so the investor needs to be compensated with additional yield,” says Jim Barnes, director of fixed income at Bryn Mawr Trust Co. in Berwyn, Pennsylvania.

The longer the bond maturity is, the more time investors have for different economic factors to take place. Due to the long period, investors are compensated for the longer holding period for bonds with a long duration since they’re taking on that risk.

For bonds that mature in a year or less, the economic environment tends to be more predictable — rather than a bond with a 30-year lifespan, which can be more prone to interest-rate risk. So there is less risk with short-term bonds, which translates to lower returns.

When you buy a bond, you are lending money to an entity. So there’s always going to be some degree of possibility that it might not give the borrowed money back. Some issuers are more speculative than others, Barnes says.

Bonds that are in a high-yield market can have a weaker credit rating like CCC with Standard & Poor’s or Fitch Ratings, two major bond rating agencies. A CCC rating, which is similar to a Caa2 rating with Moody’s Investors Service, refers to noninvestment-grade, high-yielding bonds with substantial risks.

Investors holding these securities need to know there is a greater possibility of the issuer not fulfilling its debt obligations. Therefore, the investor needs to be compensated with more yield due to the higher credit risk of the debt security.

“The more credit risk you take on, the more yield you will be compensated with as an investor. But you have to determine if you’re comfortable taking on that risk,” Barnes says.

U.S. government bonds, for example, don’t hold as much credit risk because they act as a benchmark for the interest rates on debt securities and are backed by the U.S. government.

A high-yield corporate bond, on the other hand, has a low credit rating and carries a higher credit risk and default risk.

[SEE: 8 Stocks to Buy for Your 401(k).]

How to Diversify Your Debt Securities

The approach to diversification includes holding debt securities that have a mix of the different maturities and varying levels of credit risk.

To diversify your bond portfolio, experts say you need a variety of bond funds — either bond mutual funds or exchange-traded funds and different types of debt securities. The Vanguard Total Bond Market ETF ( BND), for example, offers broad exposure to the U.S. bond market at an affordable price and is appropriate for the average investor seeking fixed income.

“A bond investor could have a mix of four different bond funds such as short-term, intermediate-term and long-term with a little bit of high-yield exposure through corporates,” says Linda Erickson, founding partner and a financial advisor at Erickson Advisors in Greensboro, North Carolina.

Your bond portfolio can include municipals, U.S. Treasurys, higher-grade and lower-grade debt, explains James Biagi, associate teaching professor at Stevens Institute of Technology in Hoboken, New Jersey. “You want to spread out your risk among different securities.”

Experts recommend for the average investor to look to bond funds rather than individual bond positions. Individual bonds put more onus on the investor to keep up with the well-being of the issuer, making sure it’s in a liquid position. You are effectively left to manage your market and interest-rate risk.

“Individual bond issuances involve higher risk. If that bond can’t pay, there’s a chance of losing your money. That’s why you always have to look at the creditworthiness of the issuer,” Biagi says.

When investing in bonds, it’s important to watch out for inflation because when inflation starts to increase, it kills purchasing power. “Add debt securities that protect against inflation and that can hold their level of purchasing power,” Barnes recommends.

Treasury inflation-protected securities, or TIPS, are an example of inflation-protected securities, which pay interest at a fixed rate. When inflation is present, interest payments rise; the inverse occurs when deflation is present.

Generally, it’s important to understand the risks of each security and the objective of each portion of your portfolio.

“You could have a portion in your portfolio that’s in liquid securities like U.S. governments for cash or emergencies but have another portion of your portfolio where you have no intentions of selling,” Barnes says.

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How to Enhance Fixed-Income Returns

To enhance returns on their investments, investors need to look within and evaluate their risk tolerance.

Whether you aim to grow your capital or preserve it, a diversified fixed-income portfolio can help maintain your asset value or capital appreciation.

Investors tend to turn to equities for growth, but fixed income can offer this potential as well. “You can build a portfolio of fixed income and have some portion geared toward growing your capital,” Barnes explains.

He says this is done by diversifying your bond maturity and investing in certain fixed-income sectors that are more speculative to capture a higher yield.

Investors need to assess what levels of bond maturity they want to hold. With a short-term bond strategy, investors should expect a lower rate of return since they’re taking less risk. Short-term bond funds are used for clients who are anxious about increasing interest rates, but when interest rates are expected to decline, investors would look at long-term bond maturity.

“Investors concerned about liquidity and safety would go shorter term and have a portfolio of government securities,” Erickson says.

But if interest rates are going negative, you may want to lock in a 30-year rate, she adds.

Anyone who wants an increased rate of return on their money will not get there by having their cash sitting in a bank. Chances are, over time, inflation will eat at its value. Investing in the bond market can be a sustainable way to get a higher return on your money. Since we’re in a low-yield economic environment, investors are turning to high-yield bond funds or “junk bonds,” which increases their portfolio risk but offers a higher rate of return on their investment.

Since the entities of the bond funds are rated, “you understand the strength of the companies you’re investing in and the likelihood of them paying you back — this can lead to an increased rate of return over the money you have in the bank,” Biagi says.

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