- 1). Diversify. The quickest and easiest step to managing portfolio risk is to have a true portfolio. You accomplish this by investing in a number of different issues. Ideally, your portfolio should include bonds from companies of many different industries, with a diverse set of customers, from many different places on the map. Include international companies, as well as small-cap and large-cap companies.
- 2). Look for higher credit quality. The major credit ratings agencies, such as Moody's and Standard & Poor's, have created a ratings scale to act as a kind of shorthand for security analysis. The ratings agencies evaluate each rated bond issuer for credit quality. Specifically, they look at the expected ability of each company to pay scheduled principal and interest payments in a variety of economic conditions. Companies with "B" ratings or lower are likely to default in poor economies, while companies with "A" ratings all the way through "AAA" are expected to be able to pay debts even in the event of severe economic downturns.
- 3). Identify bond issuers with substantial assets. Companies with large cash positions are especially good. Consider the worst-case scenario: If a company is utterly unable to fulfill its bond repayment obligations, it will eventually be liquidated in bankruptcy. If the liquidation value of the company is greater than its outstanding bond obligations, and if bankruptcy law is properly applied, the bondholders will likely be made whole, though the process could take a long time. Look for durable assets that hold their value, such as real estate or proven mineral reserves.
- 4). Do the math. If you are actively managing a bond portfolio, you should be constantly vigilant for changes in the default rate in bonds of like credit quality. Make sure you are getting an effective yield to maturity -- the effective yield for bonds purchased in the secondary market that may be higher or lower than the bond's coupon rate -- to compensate you for any excess risk you take on. In all cases, your effective yield to maturity should be greater than the return you could get simply by investing in risk-free securities or treasuries with the desired maturity dates.
- 5). Allocate a portion of your portfolio to treasuries. While Treasury debt is subject to market fluctuations, the ability and willingness of the U.S. Treasury to pay its debts is still unquestioned, and the full faith and credit of the U.S. Treasury is still considered the best credit risk in the world. These bonds are backed by the power of the U.S. government to raise taxes and print money to fulfill its obligations.
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