Analysis of Asset Allocation

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Build the portfolio that fits your financial objectives

As you build your fixed income portfolio, you can use different techniques to better fit with your financial goals and risk tolerance. In this section we focus on bonds and not balance between cash, equities and bonds.

The different techniques are:

DIVERSIFICATION OF CREDIT RISKS.

As we have seen, credit quality of the issuer is one of the risks you have as a bond investor. If you only purchase bonds issued by one issuer or from the same sector of activity, you take a huge credit risk on your portfolio. If you have a downturn in the sector or if the company has difficulties, the impact on your portfolio will be dramatic. Diversifying investments between different sectors and companies make good sense, especially if you want to invest in the High Yield market (junk bonds). If your portfolio is diversified, you can hope that a downturn in a particular sector will be offset by an upturn in another sector.

DIVERSIFICATION OF MATURITIES.

We have seen that prices are linked to interest rates fluctuations. One way to diversify this risk is to purchase bonds with a range of maturities. This techniques is called Laddering and reduce your portfolio's exposure to interest rate fluctuations. For example, in place of purchasing one bond with a 10 years maturity for USD 1,000, you purchase the same amount but on different maturities, USD 100 on 1 year, 2 years, 3 years, 4 years, 5 years, 6 years, 7 years, 8 years, 9 years, and 10 years. This means that you always have a bond that is closed to the maturity and as such closed to 100%. When it matures, you reinvest the proceed for 10 years so that your portfolio is always balanced. Of course the price to pay for such a portfolio is often a lower return but the volatility of the portfolio will be much lower.

Another technique used to reduce risk be diversification of maturities is to invest only on the short term and the very long term. This technique is called Barbell and can be used when the amount available to invest is too low to allow a 'Laddering' diversification.

Another good method to have a diversified portfolio of bonds in to invest in a bond fund.

USE OF DERIVATIVES.

This technique is generally for big portfolios. You can diversify you credit risk without taking care of the maturities of the bonds. Afterward you can construct your 'Laddering' diversification by the use of derivatives that will swap the maturity of some papers or will readjust the average life of the portfolio.

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