As you build your investment portfolio of fixed-income strategies, there are various techniques you and your investment professional can use to help you match your investment goals with your risk tolerance.

Diversification

No matter what your investment objective, it makes good sense to diversify your portfolio. Diversity can provide some protection for your portfolio, so if one sector or asset class is in the midst of a cyclical downturn, the rising value of another class of assets may help offset the negative impact. For example, suppose your portfolio held a variety of high-yield and investment-grade bonds. You chose the high-yield securities for their greater returns. The investment-grade bonds probably generate somewhat lower yields, but their ability to weather economic downturns should offset potential credit-quality concerns which could affect the high-yield securities in the portfolio.

Laddering

Laddering is the strategy of purchasing securities of various maturities. When you buy bonds with a range of maturities, a technique called laddering, you are reducing your portfolio's sensitivity to interest rate risk. If, for example, you invested only in short-term securities, the kind least sensitive to changing interest rate risk, you would have a high degree of stability, but you might be giving up yield. In the reverse, investing only in long-term securities may result in greater returns, but their prices will be more volatile, exposing you to losses should you have to sell before maturity.

Building a laddered portfolio involves buying an assortment of bonds with maturities distributed over time. For example, you might invest equal amounts in securities maturing in two, four, six, eight and 10 years. In two years, when the first bonds mature, you would reinvest the money in a 10-year maturity, maintaining the ladder. Your return would be higher than if you bought only short-term issues. Your risk would be less than if you bought only long-term issues. You would be better protected against interest rate changes than with bonds of one maturity.

If interest rates fell, you'd have to reinvest the securities maturing in two years at a lower rate, but you'd have the above-market return from the other issues. If rates rose, your total portfolio would pay a below-market return, but you could start correcting that in two years or less when your shortest issue matured.

Barbell

This strategy also involves investing in securities of more than one maturity to limit your risk against fluctuating prices. But instead of dividing your money in a series of bonds distributed over time, as with a laddered portfolio, you'd concentrate your holdings in bonds with maturities at both ends of the spectrum, long- and short-term-for example, bills or notes maturing in six months or a year, and 20- or 30-year bonds.

Bond Swap

Investors use bond swaps to realize a variety of benefits. A swap, the simultaneous sale of one security and the purchase of another, may be done to change maturities, upgrade the credit quality of the portfolio, increase current income or achieve a number of other objectives. The most common swap is done to achieve tax savings. Anyone owning bonds selling below their purchase price and having capital gains or other income which could be partially, or fully, offset by a tax loss can benefit from a tax swap. In a two-step process, the investor would sell a bond that is worth less than what he paid for it and would simultaneously purchase a similar bond at approximately the same price. By swapping the securities, the investor has converted the paper loss to an actual loss which can be used to offset capital gains.

Now that you know the basic concepts of investing in bonds, talk with your investment representative about what types of bonds are most appropriate for you. He or she will be able to provide you more detailed information about each of the specific types of bonds in which you may be interested.

Duration

It is the technique most commonly by the financial institutions, Fund managers and institutional investors across the globe. As mentioned earlier, any change in interest rates effect the investments on two sides – one, you incur capital gain (in case interest rates fall) or loss (if interest rates rise) and two, you can invest the intermediate cash flows at a higher reinvestment rate. Both these effects work in opposite directions and offset each other. There is one time period where these two effects exactly offset each other and that time period is known as Duration. Duration is the weighted average maturity of the instrument weighted by the present value of the cash flows. During that time period, your interest rate risk is immunized or minimized. So the best way to immunize your interest rate risk is to match your holding period with the Duration, a strategy known as immunization.

Now one may wonder, do I need to try all permutations and combinations to get the duration of the instrument? The answer is no. There exists a straightforward methodology to calculate Duration. First of all, define your cashflows, both inflows and outflows. Then find the present value of these cash flows using your required rate of return and sum it up. Divide it by the sum of the number of years for which the instrument is outstanding and presto, you get the duration of that instrument.

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