How to invest in bonds for portfolio diversification

The standard guidance most investors follow is to maintain a portfolio with an appropriate mix of equities, bonds and cash—in short, they avoid having all their eggs in one basket. That’s because portfolio diversification can help your portfolio weather market turbulence , increasing the likelihood that you’ll see relatively consistent investment performance over time.

Bonds play an important role in a well-diversified portfolio because they tend to balance the potential volatility of higher-risk investments, such as equities . Bonds as an asset class have not historically kept pace with stock market returns, but they do typically experience less short-term price volatility.

“In times when growth assets like stocks don't perform well, bonds often hold up better and act as a smoothing mechanism over time,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management.

Below, we’ll look at the current bond environment, explain how to invest in bonds for diversification, and examine at the different types of high-quality bonds.

Today’s bond market environment

As you consider your options for investing in bonds, it’s important to assess the best opportunities in the market given today's interest rate environment .

Before 2022, interest rates were near historically low levels. Then, to help temper a sudden upturn in the inflation rate, the Federal Reserve (Fed) shifted its monetary policy. The Fed raised the short-term federal funds target rate 11 times, from near 0% to a range of 5.25% to 5.50%. That resulted in higher yields across the bond market.

One benchmark measure of interest rates is the 10-year U.S. Treasury note yield. From the start of 2022 through the early months of 2024, yields moved dramatically higher.

Source: U.S. Department of the Treasury, Daily Treasury Par Yield Curve Rates, Market Yield on 10-year Treasury securities at constant maturity.

“The Fed has signaled that it is finished raising the fed funds rate, but we don’t know when rate cuts will commence,” says Haworth. “However, there is some sense that long-term bond rates are near a peak for the current cycle.”

He notes that in the current environment, interest rate sensitivity is more prevalent. “For those investing in longer-maturity bonds, which are subject to greater interest rate risk, investors have to ask themselves if they are getting compensated for the risk they are taking,” he says.

He adds that in early 2024, the risk–reward payoff has been more attractive for those investing in municipal bonds than for investors focused on Treasury and corporate bonds.

The bond market is in an unusual environment since late 2022, called an inverted yield curve . An inverted yield curve means that shorter-term fixed income securities are paying higher yields than those of longer-term bonds. Usually, bond yields are higher for those willing to invest in a longer-term debt security. This is another factor that you should consider when devising your bond investment strategy.

Source: U.S. Department of the Treasury, Daily Treasury Par Yield Curve Rates.

Bond risk and performance in an uncertain economy

“People choose to invest in bonds for different reasons,” notes Haworth. “First, they provide a consistent and steady income stream, and the principal is usually repaid when the bond matures. A second reason is that in most environments, if the economy slows, interest rates tend to fall, which boosts bond prices.”

That positive price action, he adds, often helps “smooth the ride” for investors by mitigating some of the volatility inherent in owning equities. Equities prices are typically under pressure in periods of slowing economic growth.

This isn’t always the case, though. For example, a rising interest rate environment often results in lower prices for bonds. This is a rare circumstance when bond performance doesn’t help offset a negative turn in the stock market. “In most periods, we’ll see a somewhat opposite correlation between bonds and stocks,” says Haworth.

How to buy bonds: An overview

One rule of thumb is that a diversified portfolio should contain 60% in equities and 40% in fixed income investments. Keep in mind this is a broad guideline, and the specific mix in your portfolio should be based on your own objectives, investment time horizon and risk tolerance.

As far as the bond portion of your portfolio, there are a few things to consider, including bond quality and the different types of bonds available.

How to assess bond quality

When seeking to diversify a portfolio with bonds, know that not all bonds are equal. “Some investors think that if they load up on high-yield bonds [which have lower credit quality], they’re diversified, but that’s not the case," Haworth says.

While high-yield bonds can add value to a portfolio, they’re often nearly as volatile as stocks and may not provide the balance you’re trying to achieve.

Instead, high-quality bonds, including Treasury bonds and corporate debt securities, can be a better choice for portfolio diversification. Bond issuers from this category of fixed-income investments are likely to see the value of their issues hold up better during times of economic uncertainty, when stocks are most susceptible to downturns.

“Quality is a measure of the likelihood of default by a bond issuer, which can include missing interest payments to bondholders or failing to repay principal when bonds reach maturity,” says Haworth.

In the case of bonds, quality is measured by the issuers’ bond ratings, which are assessed by independent ratings agencies. Investment-grade bonds (those with a lower risk of default) have ratings of or above BAA (on the ratings scale used by Moody’s) or BBB (on the scale used by Standard & Poor’s or Fitch).

Types of bonds to consider for diversification

Just as there are different types of equities, there are different types of bonds, each with its own characteristics. Haworth suggests choosing from the following lower-risk options to help you diversify a portfolio that includes equities:

What are government bonds?

Government bonds are issued by stable governments from developing economies with the powers of taxation, including the U.S., Germany, Japan and Canada. U.S. government bonds are called Treasury bonds (T-bonds).

Many turn to U.S. government securities in times of economic distress, viewing these bonds as a “safe haven.” U.S. Treasury bonds, for example, have never defaulted. Because of its taxing authority and the ability to issue debt as needed, the federal government is considered the most reliable bond issuer. Treasury bond interest is taxable.

How to buy government bonds

The TresuryDirect website , which is run by the U.S. government, is the only place you can electronically buy and redeem Treasury bonds. You can also buy them in bulk through a broker or a bank or as part of an exchange-traded fund (ETF) or mutual fund.

What are municipal bonds?

Also called “muni bonds,” these are backed by taxes and revenues from state and local jurisdictions. Many well-funded entities have ample assets and taxing authority to back general obligation (GO) bonds. Revenue bonds issued by providers of essential services such as water and sewer services can be another stable option in the muni bond category. Yields on municipal bonds are typically lower than yields on comparable Treasury or corporate bonds, because the interest paid is generally exempt from federal income taxation, and in some cases, from state taxation.

How to buy municipal bonds

You can buy individual municipal bonds through a brokerage firm or bank or invest in a pool of municipal bonds via a mutual fund or ETF. As you assess your options, you want to compare the tax-equivalent yield generated by municipal bonds compared with other types of bonds.

What are GSE-issued agency bonds?

Government-sponsored enterprises such as Fannie Mae and Freddie Mac provide credit and other financial services to the public. These bonds are now fully backed by the U.S. government, so they carry credit quality similar to U.S. Treasury debt. The interest these bonds pay is taxable.

How to buy government-backed agency bonds

You can buy individual agency bonds through a broker or bank, or you can invest in a pool of such bonds via a mutual fund or ETF.

What are corporate bonds?

To find highly rated, high-quality corporate bonds, look for well-established companies with diversified product offerings and a long track record of financial stability and success. These bonds tend to generate higher yields than government or municipal bonds, and the interest paid is treated as taxable income.

How to buy corporate bonds

You can buy individual corporate bonds through a brokerage firm, bank or bond trader, or invest in a pool of corporate bonds via a mutual fund or ETF.

What are mortgage-backed security bonds?

Also known as mortgage-backed securities (MBS), these bonds are secured by commercial or residential property mortgages and can be a good choice to achieve bond portfolio diversification. These bonds, with higher-quality ratings, tend to benefit from their focus on borrowers with an ability to make timely mortgage payments.

How to buy mortgage-backed securities

You can buy individual MBS through a brokerage firm, bank or bond trader, or invest in a pool of MBS via a mutual fund or ETF.

Other considerations in building a bond portfolio

Consider conducting a risk assessment before determining how to invest in bonds for diversification. For example, if your goal is to generate higher yields, you must be willing to accept more risk.

Along with quality considerations, it’s also important to assess the average maturity of bonds held in your portfolio. “Shorter-maturity bonds are less sensitive to the impact of interest rate changes,” says Haworth. “In an environment of rising interest rates, bonds with longer maturities will typically experience more downward price pressure.”

Before investing in bonds or any other asset class, review your portfolio strategy with a financial professional. Consider your investment time horizon, financial goals and desired level of risk. And remember that your long-term goals shouldn’t change just because the market is dealing with short-term volatility. As always, investing is a long-term game.

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