Portfolio Construction

Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.

One of the main advantages of constructing a portfolio of individual bonds is that it can be customized to meet the precise needs, wants, and objectives of the investor. While this approach allows for a portfolio that is tailored to an investor’s personal preferences, it requires some upfront consideration and analysis to ensure that the portfolio is in line with an investor’s targets. While not all-inclusive and in no particular order, the following paragraphs outline important areas of consideration when constructing a customized fixed income portfolio.

Objective At a high level, answer the question, “What is this portion of the portfolio trying to accomplish?” Is it earmarked to pay a tax bill next year? If so, minimal credit risk and a single maturity date just before taxes are due are likely appropriate. Is it a cash alternative account with regular liquidity needs? A short-term ladder with frequent maturities might make sense. Is it meant to preserve wealth and provide stability in your portfolio for years to come? Are you retiring and need this investment to produce cash flow to fund your lifestyle? The range of personal objectives are endless but determining the investment objective is important as it will guide the overall allocation process.

Liquidity Needs What are your near-term and long-term liquidity needs, if any? Sometimes, there are none and the fixed income allocation is just meant to preserve your wealth and for future generations. This would allow maximum flexibility to invest all along the yield curve depending on where the most value is right now. Is it a qualified account and a required minimum distribution must be made annually? Are you a real estate investor and need access to these funds over the next few years to make new investments? Perhaps you are retiring in 5 years and plan on using some of these funds to purchase that boat you have always wanted. Identifying any upcoming liquidity needs helps to ensure that money is available when you need it. One of the great things about owning individual bonds is that you can line up the maturity dates of specific investments with liquidity needs so you aren’t subject to market risk when the time comes to access your money.

Tax Bracket Identifying both your federal tax bracket and state tax bracket is important for ensuring that the most tax-efficient product is selected. Being aware of potential tax bracket changes that might be on the horizon is also important. If you’re a high-earner retiring in a couple years, oftentimes your tax bracket can change considerably and it might make sense to factor in the longer-run tax situation. A potential move to a different state is also an important consideration for many investors.