5 Choosing bonds
The apple-pie and motherhood principle of the investment industry is that having in
one’s portfolio different types of securities, which essentially means practicing diver-
sification, helps in reducing risk. If one falls in value, others may rise in value at the
same time, potentially making up for some of the loss. The way such logic goes, this
should guide the hand of investors in choosing bonds. Or, isn’t it quite so?
Starting with the fundamentals, during periods of volatility, a portfolio that includes
investments in both equities and debt instruments may not decline in value as much
as one that is focused only on stocks or only on bonds. At the same time, however,
effective diversification requires much more than just adding different investments to
one’s portfolio. On the bonds’ side, for instance, it will be wise to differentiate among
different types of debt investments – government and corporate bonds, for example.
Often, though not always, government debt is a rather conservative investment
option, if backed by full faith and high credit of the issuing sovereign. But also
government bonds offer lower yields than those of other issuers, therefore the
portfolio’s rate of return will tend to be low.
Usually, corporate bonds pay higher yields than government debt, but they are also
riskier than the latter. For instance, credit risk may be high, as with junk bonds,
because the issuer company may not be able to continue paying interest and on matur-
ity repay principal to the investor. Moreover, the issuance of corporate bonds tends
to be concentrated on a relatively small number of industries.
Among corporates, frequent debt instrument issuers are the motor vehicle and air
transport industries, followed by telecommunications, information technology, and
the energy sector. Some of these industries, like air transport, are risky because they
are too much leveraged, their products are aging or alternatively too new and untested.
In other cases, mismanagement has taken the upper hand, and for other reasons.
Investors should therefore carefully weigh advantage and disadvantages of one
alternative against the other – for instance, more attractive income against the
downside of greater counterparty risk. Up to a point, protection of principal can be
obtained by concentrating on higher credit quality of debt instruments, and by
practicing a policy of diversification among:
Maturity dates, and
This brings into perspective some of the criteria regarding choices to be made, which
indeed go well beyond government debt and corporates. There are many segments in