The vital role bonds play
in a diversified portfolio
June 2015
How to stay on track toward your goals even when markets change
When the Federal Reserve began scaling back its bond-
“Fixed income investments, like any asset class in your
buying economic stimulus program in mid-2013, skittish
portfolio, should never be considered in isolation from
investors quickly sold their bonds. That drove down prices
the rest of your investments,” he says. Bonds and
and — because bond yields rise when prices drop — the
other fixed income investments, along with equities,
yield on 10-year Treasury notes almost doubled, from
play an important role in a diversified portfolio. Their
1.76% to 3.03% by the end of 2013.
contribution — whether for income or to counterbalance
But in 2014, investors who expected that interest rates
equity investments — is critical.
would continue to rise faced another dilemma. Instead of
That means keeping in mind how your fixed income
moving up, the yield on 10-year Treasuries moved back
investments tie into your goals and overall investment
down to 1.7% by year end. Even as the Fed forecasted the
strategy. “Even if you’re saving for a goal like retirement
return of higher interest rates in 2015, uncertainty about
that is 10 or 20 years away, it’s important to regularly
the timing and extent of rate changes has left many bond
monitor your fixed income allocation,” Gonzalez says.
investors wondering: What is the best course of action
when interest rates are so unpredictable?
You also should be mindful of how different types of
bonds introduce different risks into your portfolio.
“Creating a diversified bond portfolio with appropriate
(For a quick review of the key risks of investing in
levels of risk that performs reasonably well even when
bonds, read our “Understanding Types of Bond Risks”
markets don’t move as expected can help you stay on
fact sheet.)
course toward your investment goals,” says Yago Gonzalez,
senior portfolio manager, Merrill Lynch Investment
Management & Guidance. It also can offer potential
protection against interest rate changes and other risks.
Know why you are investing in fixed income
To start, take a big-picture perspective as you review your
bonds and other fixed income investments. “Begin by asking
yourself why you are investing in fixed income securities in
Finally, it’s important not to overreact to market events
and movements. Because no one knows for sure what the
financial markets will do next week, next month or next
“Fixed income investments, like any asset class in your portfolio,
should never be considered in isolation from the rest of
your investments.”
— Yago Gonzalez,
senior portfolio manager,
Merrill Lynch Investment Management & Guidance
the first place,” suggests Gonzalez.
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May Lose Value
year, it’s usually a good idea to maintain some exposure
performance characteristics of the equity investments that
to bond investments as part of a diversified portfolio.
you own. You might decide to build an overall portfolio of
“Bonds continue to play an important role in long-term
investments that looks like the “moderately aggressive”
portfolio allocation by providing stability, diversification
allocation below, balancing a 70% allocation in equities
and income,” says Martin Mauro, fixed income strategist,
with 25% in fixed income investments and 5% in cash.
BofA Merrill Lynch Global Research.
If your goal is to generate income
How much of your overall portfolio should
be in bonds?
Let’s say you’re a soon-to-retire investor who will be
While having a bond component in your portfolio is
depending on bonds to provide income in retirement. You
could build a portfolio with a higher proportion of fixed
income investments that looks like the “conservative”
important, it’s “your individual objective and your risk
allocation in the chart below.
tolerance that will determine the amount of your
fixed income allocation and which bonds you own,”
The sample asset allocation portfolios below show how
Gonzalez explains.
different mixes of investments can potentially generate
different levels of risk and return for your overall portfolio.
If your goal is to offset equity risk
The Asset AllocatorTM at merrilledge.com can help you
If you’re a younger investor with a more aggressive
investment style, the main role of bonds in your portfolio
typically will be to counterbalance some of the risks and
find an appropriate asset allocation approach based on your
personal risk profile.
Sample asset allocation portfolios
While bond investments are typically part of a diversified investing strategy, the amount you include in your overall portfolio will change
depending on your goals, time line, liquidity needs and tolerance for risk. Historically, portfolios with larger allocations to stocks/equities
produced better returns over time, but with greater volatility risk than those with larger bond/fixed income allocations.
RISK PROFILE
Conservative
Moderately conservative
Moderate
Moderately aggressive
Aggressive
INVESTMENT
OBJECTIVE
Portfolio stability and
preservation of capital
Modest portfolio appreciation
with minimum principal loss
Portfolio stability and
appreciation
Portfolio appreciation
over time
Above-average portfolio
appreciation over time
Equities
Fixed income
5%
40%
5%
Average
5%
15%
25%
35%
60%
50%
55%
Best
10%
20%
25%
Asset Allocation*
Cash
Worst
80%
53.21%
49.95%
46.75%
39.44%
70%
30.42%
Annual Returns**
11.50%
11.01%
9.91%
8.55%
11.99%
-8.00%
-17.11%
-26.04%
-30.44%
-34.79%
*Data compiled from the BofA Merrill Lynch Global Research Investment Committee (RIC Report), 05/12/2015; Strategic Asset Allocation Models: Analysis of 36 Years in Rolling 12-Month
Periods (1/1978 – 12/2013), Merrill Lynch Investment Management & Guidance, 05/2015.
The strategic allocations are identified by Merrill Lynch Global Wealth Management and are designed to serve as guidelines for a 20- to 30-year investment horizon. These allocations are
intended for clients with the highest liquidity needs.
**Results shown are based on indexes and are illustrative only, do not account for the impact of transaction costs or taxes and do not reflect the actual investment experience of any
investor and the allocation for each current model remaining consistent. Historically, portfolios with a higher allocation to equities (stocks) tend to have more volatile returns. Source:
Merrill Lynch Investment Management & Guidance, 05/2015.
Merrill Lynch has changed the models in the past and may do so in the future. Past performance does not guarantee future results.
Index sources: Equities – S&P 500 Index; Bonds – BofA Merrill Lynch U.S. Broad Market Bond Index; Cash – BofA Merrill Lynch 3-Month T-Bill Total Return Index. Direct investment cannot
be made in an index.
2
What types of bonds should you choose?
The chart below shows how the fixed income portion of
an investment portfolio might be allocated according to
But what types of investments should you choose for
five different investor profiles. The more conservative
that bonds portion of your portfolio — your “sub-asset
allocation?” Here are four bond investing tactics to consider:
1.Use diversification to your advantage
portfolios, for example, hold a higher percentage of
“safer” Treasuries and CDs. The more aggressive ones
include more corporate, high-yield and international
“To help get the most out of your fixed income
bonds to seek higher returns. A moderate portfolio mix
investments, you need a well-diversified portfolio that
likely would fall somewhere in between.
manages overall market risk,” explains Gonzalez. You
2.Vary maturities to balance risk and return
should consider doing that by investing in a mix of
Varying the maturity dates of the bonds you own also
Treasuries, CDs and U.S. agency securities, mortgage-
can help you diversify your bond portfolio and make the
backed bonds, investment-grade corporate bonds
appropriate trade-offs between a bond’s maturity and
(and preferred stocks), high-yield bonds and possibly
its sensitivity to interest rate changes. Longer-term
international bonds.
Treasury bonds, for instance, are far more sensitive to
The amount you allocate to each of these sectors
interest rate risk than shorter-term 30-day Treasuries.
will vary based on your goals and risk profile. If you
But short-term Treasuries historically have lower yields.
are looking for diversification to balance your stock/
For example, as of May 12, 2015, the yield on a 3-month
equity allocation, for example, you may want to include
Treasury bill was 0.01% while the yield on a 30-year
Treasuries and U.S. agency securities because these
Treasury bond was 3.01%.1
investments historically have “negative correlations” to
Mauro suggests including some intermediate-maturity
stocks. This means that when one type of investment
bond funds as well because they can add yield and
performs poorly, the other will likely perform well.
diversification while also balancing shorter-term fixed
“Having Treasuries in your mix can be one of the best
income securities such as Treasuries. For more on
ways to diversify your stock investments because of
bond maturities and interest rate risk, see page 5 and
their low correlation to equities,” says Mauro.
also read our “How to Manage Your Fixed Income
Similarly, Gonzalez cautions, “You also want to be careful
Investments When Interest Rates Rise” topic paper.
not to load up too heavily on high-yield bonds because
they have a strong positive correlation to stocks.”
Bond sector allocations for the fixed income portion of a diversified portfolio
The amount and types of fixed income investments that you select within the fixed income portion of your portfolio should be based
on your individual needs and risk tolerance. The allocations below, from the BofA Merrill Lynch Global Research RIC Report, can be
used as a starting point for choosing the types of bonds to include in your own fixed income mix.2
Conservative
Moderately
conservative
Moderate
Moderately
aggressive
Aggressive
Treasuries, CDs and government agency bonds
65%
55%
40%
25%
15%
Mortgage-backed bonds
25%
25%
25%
25%
25%
Investment-grade corporate bonds (and preferred stocks)
10%
20%
25%
35%
40%
High-yield bonds
0%
0%
5%
5%
10%
International bonds
0%
0%
5%
10%
10%
BOND SECTOR ALLOCATIONS
Source: Data compiled from the BofA Merrill Lynch Global Research RIC Report, 05/12/2015.
The strategic allocations are identified by Merrill Lynch Global Wealth Management and are designed to serve as guidelines for a 20- to 30-year investment horizon.
3
3.Seek more income in higher-yielding asset classes
When investing for income, “it’s critical to have exposure
or bond fund over any performance period or for the life
to asset classes that have the potential for higher
of the bond.
returns, in particular both investment-grade and highyield corporate bonds,” Gonzalez says. This can be
Decide how you want to invest
done by investing in a mix of higher-yielding, income-
After you have identified your fixed income investing goals
producing investments such as:
and the types of bond investments that can help you meet
• Investment-grade and high-yield corporate bonds
• Non-agency mortgage-backed securities (issued by
private financial institutions rather than government
agencies such as Fannie Mae or Freddie Mac)
• Preferred stocks (an equity/fixed income hybrid)
• Floating-rate loans
• Emerging-market bonds issued in both local
currencies and U.S. dollars
them, what’s the best way to build your bond portfolio?
If you have substantial assets and want to take a more
tactical, hands-on approach to diversification, you might
want to build a portfolio using individual bonds.
However, most investors will opt to include bonds in their
mix by purchasing shares in bond mutual funds and/or
exchange-traded funds (ETFs). And, if you choose actively
managed bond mutual funds, you also get the expertise
of a professional portfolio manager who can respond
While many of these higher-yield vehicles have more
appropriately to market opportunities — so you can focus
credit risk and less interest rate risk, the benefit of
your time and attention elsewhere.
diversifying among them is that you can limit your
overall risk exposure. The goal is to achieve an attractive
level of income with an acceptable level of risk.
4.Focus on total return
If you are investing in fixed income securities to produce
regular income, you also will want to keep an eye on your
bonds’ or bond funds’ total return. Total return includes
what the bond pays you in interest over time plus any
capital appreciation or loss resulting from a rise or fall
in the bond’s price when it is sold. Essentially, total
You can add a diversified mix of fixed income investments
to your portfolio by using funds in two ways:
1.Choose a single, multi-sector fixed income fund
You can achieve a fairly well-diversified bond portfolio
with a minimum outlay of assets and effort by using
a single, taxable fixed income mutual fund3 or ETF
that invests in a variety of Treasuries, agency bonds,
mortgage-backed securities and corporate bonds
across a range of maturities. (Tax-exempt muni bonds
What about munis?
provide attractive after-tax income potential,”4 says
Because the interest that municipal bonds (or “munis”)
Jasmine Yu, head of global fixed income due diligence,
pay is normally exempt from federal income taxes,
Merrill Lynch Investment Management & Guidance.
they are often used by high-income taxpayers looking
Munis are still subject to interest rate and credit risks.
to generate extra income without burdensome taxes
However, because the underlying issuers are different
in their non-retirement portfolios. But even if you’re
in municipal bond, corporate bond and Treasury bond
not seeking immediate tax relief, you might still want
sectors, allocations to municipal bonds can potentially
to consider including munis in your fixed income
increase diversification of returns and reduce overall
investment mix for the additional return potential and
fixed income portfolio volatility.
extra diversification they can provide.
“So long as you’re selective and you align your choices
with your overall investment strategy, munis can
4
return is the full amount you will have earned on a bond
Merrill Edge® clients who would like more information
on municipal bonds can visit the Fixed Income section
of merrilledge.com for details (login required).
are not included.) The actively managed funds in this
category try to deliver small incremental returns beyond
What’s in a name?
a particular benchmark, such as the Barclays Aggregate
When you use a fund screener (such as the Fixed
Bond Index. Two of your choices include:
Income Screener in the Asset AllocatorTM) to choose
• “Core” bond funds that offer broad diversification
across the U.S. investment-grade bond market.
• “Core Plus” bond funds that add high-yield corporate
securities and international bonds to the typical Core
bond fund allocation, taking on more risk to seek
better returns. “This mix has the potential to deliver
slightly higher returns (the ‘plus’) than a Core bond
fund alone would,” Gonzalez says. “But you may be
taking on greater risk.”
fixed income mutual funds or ETFs, remember that
bond funds don’t follow a standardized naming
convention. That means you may find different names
used for the same kinds of mutual funds or ETFs.
For example, a broadly diversified taxable bond fund
that invests across a number of sectors may be
called a Core bond fund, a Total Return bond fund, an
Aggregate bond fund or even an Intermediate bond
fund. That’s why it’s important to check what the fund
actually invests in before making your selection.
You also might consider allocating a small portion
of your bond assets to an “unconstrained bond fund.”
Unlike traditional bond funds that tend to mimic bond
allocation and any changes in your goals. In addition, you
indexes more closely, these actively managed funds
may need to rebalance your bond allocation (just as you
have the latitude to “go anywhere” in the fixed income
do your asset allocation) if it changes due to investment
universe to seek better returns. Be aware that the
performance. For more on how to rebalance, read our
additional flexibility may entail a different set of risks.
2.Build your own portfolio of funds
If you already own some bond mutual funds or ETFs,
“Portfolio Rebalancing: How to Pursue Growth and
Manage Risk” topic paper.
you may want to build your own portfolio of funds
What you can do if interest rates rise
following one of the bond sector allocations shown
What if interest rates rise and threaten to reduce the
in the chart on page 3. If you are a Merrill Edge client,
value of some of your bond investments — as they did
you can use the Asset Allocator at merrilledge.com to
in 2013? If you’re properly diversified, there’s no need
help you find an appropriate asset allocation for your
for panic, says John Manetta, senior portfolio manager,
situation. Within the Asset Allocator, use the Fixed
Merrill Lynch Investment Management & Guidance.
Income Screener to narrow your search and customize
your views of specific bond mutual funds and ETFs.
Before you add a new fund to your fixed income
“Weaker than expected global growth in 2014 was
associated with further declines in rates. If growth
improves, expect rates to move higher gradually,” he says.
portfolio, make sure you understand the types
For a more detailed look at the impact of interest rates
of securities it will invest in, because the mix of
on your bond portfolio, read our “How to Manage Your
investments can vary widely from fund to fund. You
Fixed Income Investments When Interest Rates Rise”
want to know that the funds you finally choose include
topic paper. In the meantime, here are some ways you can
the types of investments and level of risk you are
manage your fixed income portfolio in anticipation of rising
comfortable with.
market interest rates:
Revisit and rebalance
• Shorten maturities to manage interest rate risk
Once you’ve created a mix of bond investments that
If you anticipate that interest rates will go up in the
you’re comfortable with, you’ll want to review it regularly
future, you may want to limit your exposure to rising
to make sure the mix is still in line with both your original
interest rates by reducing the maturities of the notes or
5
Treasury funds you own, Mauro says, because shorter-
• Build ladders
maturity bonds are less sensitive to interest rate
While there is always some uncertainty about when (and
movements. For times of interest rate uncertainty,
how quickly) rates will rise and fall in the future, a ladder
such as early 2015, he prefers to focus on intermediate-
of individual bonds can help reduce the effect that any
term maturities.
single bond will have on your overall bond portfolio. (For
• Move to less interest rate–sensitive sectors
While all investments carry risk, some bonds have
greater interest rate sensitivity (for example, U.S.
Treasuries) while others have higher credit risk (highyield bonds). So if you believe that interest rate risk will
be a greater concern than credit risk for the foreseeable
future, you can adjust your allocation accordingly.
High-yield bonds, for example, generally do better than
other bonds when the economy is improving, and they
tend to suffer less damage when Treasury yields rise,
says Chris Vale, senior vice president, products and
solutions, Merrill Edge. “But they also involve some
more on bond ladders, see the chart below.)
A laddered bond portfolio helps take advantage
of rising rates
Creating a “bond ladder” with staggered maturities and
reinvesting the proceeds as each bond matures can help you
moderate the effect of rising interest rates on your bond
portfolio. As shorter-term, lower-yield bonds mature, the
proceeds are reinvested at the “top” of the ladder where
longer maturity bonds offer the possibility of higher yields.
This can increase the total return for the portfolio as interest
rates rise. The diagram below illustrates the laddering concept,
using hypothetical bonds with maturities of one, three and five
years and increasing yields.
extra risk, so you need to consider that in your decision
making,” he notes. Still, as part of a balanced portfolio,
they can offer the possibility of additional returns.
of bonds and bond funds, read our “Understanding
Types of Bond Risks” fact sheet.
3 YR
• Use defined-maturity ETFs
Also known as fixed-maturity ETFs or target-date ETFs,
these funds hold bonds that are expected to mature in
Lower
Yielding
Bond
1 YR
5 YR
4 YR
2 YR
5 YR
REINVEST
5 YR
REINVEST
For more about the risks associated with different types
Higher
Yielding
Bond
3 YR
2 YR
a stated year, so they combine features of both
diversified bond portfolios and individual “bond ladders”
that target a particular date.
Defined-maturity ETFs can help investors further
diversify their fixed income holdings while limiting
exposure to interest rate risk. Also, you can create
a ladder of defined-maturity ETFs using fewer assets
YEAR 1
YEAR 2
YEAR 4
A bond ladder, depending on the types and amount of securities within the ladder,
may not ensure adequate diversification of your investment portfolio. While
diversification does not ensure a profit or guarantee against loss, a lack of
diversification may result in heightened volatility of the value of your portfolio.
You must perform your own evaluation of whether a bond ladder and the securities
held within it are consistent with your investment objective, risk tolerance, liquidity
needs and financial circumstances.
than an individual bond ladder requires.
6
If interest rates rise, “a key advantage of a ladder
Continue to explore all of your options
of defined-maturity ETFs is that — unlike traditional
Fixed income markets in the U.S. are larger, more complex
fixed income ETFs — their sensitivity to interest rate
and more diverse than equity markets. The challenge of
movements declines as their target maturity dates
investing in them is magnified by the variety and choices
approach,” explains Jon Maier, ETF strategist,
available and by the different risk/reward characteristics
managing director, Merrill Lynch Investment
that each type of fixed income investment can introduce
Management & Guidance.
into your portfolio.
Understanding the choices available for appropriately
track — and help you resist the urge to make precipitous
diversifying the fixed income piece of your overall portfolio
moves — as financial markets change in the months and
according to your goals can help you keep your portfolio on
years ahead.
How Merrill Edge can help
For more about the role bonds play in a diversified
portfolio, visit merrilledge.com/bonds to read
and view:
• “Understanding Types of Bond Risks” fact sheet
• “Why Bonds Still Matter” video
• “How to Manage Your Fixed Income Investments
When Interest Rates Rise” topic paper
• “Portfolio Rebalancing: How to Pursue Growth
and Manage Risk” topic paper
As a Merrill Edge client you have access to a variety
of products and resources to help you maintain
a diversified portfolio:
Fixed income investment products
Merrill Edge offers a wide selection of fixed income
investment products, including:
• A broad range of fixed income securities such as
U.S. Treasuries, municipals, agencies, corporates and
new-issue brokered CDs
• Bond mutual funds and ETFs
• Professional management for your fixed income
portfolio with Merrill Edge Select® Portfolios
-- To learn more, click on Managed Portfolios under
the Investing & Trading tab on merrilledge.com.
If you’re making your own investment decisions
At merrilledge.com, you’ll find exclusive online tools
and resources:
• The Asset Allocator (login required) helps you identify
an appropriate mix of investments based on your
personal risk profile and your goals.
• The Fixed Income Screener (login required) allows
you to search for individual bonds, bond mutual
funds and bond ETFs based on certain criteria. If
you are searching for bond mutual funds, be sure to
select a Category (e.g., taxable fixed income) as well
as an Objective (e.g., Core bond fund, Core Plus bond
fund) in order to narrow your results.
• Merrill Edge Select® Funds and Merrill Edge Select®
ETFs simplify the investing process by providing
you streamlined lists of mutual funds and ETFs that
have been evaluated by Merrill Lynch investment
professionals and organized so you can easily find
the ones that align with your investment strategy.
To learn more, go to the Investing & Trading tab on
merrilledge.com.
If you’d like more help with your investment
strategy
To create an investment strategy suited to your
personal financial situation — including suggested
next steps — visit merrilledge.com/fsalocator to
Fixed income reports and commentary
find a Merrill Edge Financial Solutions AdvisorTM at
For ongoing insights from BofA Merrill Lynch Global
select financial centers. Or, call us at 888.ML.INVEST
Research, you’ll find the Research Investment Committee
(888.654.6837) Monday through Friday, 8 a.m. to
(RIC) Report and “The Fixed Income Digest” by clicking
10 p.m. Eastern.
on Investing Insights under the Research tab when you
If you are not a Merrill Edge client, please
log in to your account at merrilledge.com.
visit merrilledge.com or call 888.MER.EDGE
(888.637.3343) to learn more and get started.
7
Bloomberg, May 12, 2015.
For a more detailed analysis of the risk characteristics of a variety of diversified fixed income and equity/stock portfolios, log in to your account at merrilledge.com to read the most
recent BofA Merrill Lynch Global Research RIC Report.
3
Important Note on Bond Funds: Return of principal is not guaranteed. Bond funds have the same interest rate, inflation and credit risks that are associated with the underlying bonds
owned by the fund. Generally, the value of bond funds rises when prevailing interest rates fall and falls when interest rates rise. There are ongoing fees and expenses associated with
owning shares of Bond funds.
4
Certain investors’ income may be subject to the federal Alternative Minimum Tax (AMT), and state and local taxes may also apply.
1
2
Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.
Investing in fixed income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic
developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.
Investments in high-yield bonds may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher rated categories.
Investments in international bonds involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or
other developments.
Mortgage-backed securities represent ownership in a pool of mortgage loans. For Ginnie Mae pass-through certificates, the underlying loans are insured by the
Federal Housing Administration and backed by the full faith and credit of the U.S. government, which guarantees the timely payment of principal and interest. The
underlying mortgages of Freddie Mac and Fannie Mae pass-through certificates are conventional loans. Consequently, they are not guaranteed by the U.S. government.
Since the underlying mortgages on pass-through certificates can be prepaid at any time, pass-through certificates do not offer call protection. Consequently, regardless
of the stated maturity, you may be invested for a longer or shorter period of time than you originally planned. Generally, pass-through certificates are intended as
longer-term investments.
Preferred stocks may be subject to call provisions resulting in the risk of investing proceeds at lower market rates and liquidity may be affected by the size of the issue
and its trading activity.
Exchange-Traded Funds are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor’s
shares, when redeemed or sold, may be worth more or less than their original cost.
For more complete information on any mutual fund or ETF, clients should be provided the prospectus, and/or if available, the summary
prospectus, and should read it carefully. Before investing, they should carefully consider the investment objectives, risks and charges and
expenses of a fund. This and other information can be found in the fund’s prospectus, which should be read carefully before investing.
Prospectuses for mutual funds can be obtained through the investors’ sign-in area of merrilledge.com. Clients of Merrill Edge Advisory
CenterTM can also call 888.654.6837. If you are not currently a Merrill Edge client, please call 888.637.3343.
GWM Investment Management & Guidance (IMG) provides industry-leading investment solutions, portfolio construction advice and wealth management guidance.
Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied
upon for the purpose of avoiding any tax penalties. Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should
consult your legal and/or tax advisors before making any financial decisions.
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