What’s the spread on that bond?

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When interest rates go up, bond prices go down, and vice-versa. Rising bond yields mean lower bond prices. What’s a bond investor to do?

One defense it to get a better understanding of the spread relationships among the different bond sectors and look to reduce risk by rebalancing bond allocations into sectors where credit spreads are expected to tighten rather than widen. The spread tightening, assuming it happens, partially offsets the price risk of rising interest rates.

What’s a bond sector?

What are some of the different bond sectors? Treasuries, agency bonds, municipal bonds and corporate bonds are the major U.S. bond sectors. Internationally, there is sovereign debt, corporate debt, developed, less developed and emerging market bond issuers. There’s also the distinction between short-term, intermediate-term and long-term maturities.

What’s a credit spread?

A credit spread is the difference in yield based on the difference in credit risk on bonds with the same maturity. Spreads widen when investors demand additional yield to own a riskier credit. Credit spreads tighten when investors bid up the price of riskier bonds versus lower risk bonds.

What’s cheap versus rich?

There’s always a divergence of opinion on which credit spreads are cheap, that is expecting to tighten, and which are rich, or expecting to widen. That’s what makes a market. Investment professionals recently have offered up opinions that municipals are cheap and high-yield spreads are rich.

Is that the trade?

I’m not here to provide you with specific investing advice. I’m here to say that if you want to pursue a bond reallocation based on what’s cheap and what’s rich, you have to make that determination on your own or with your investment adviser. My personal opinion is that this isn’t a portfolio asset reallocation appropriate for most do-it-yourselfers.

How do you own your bonds?

Because the bond investment can be held in different investment vehicles — bond mutual funds, exchange-traded funds (ETFs) or exchange-traded notes (ETNs), or individual bonds, it isn’t always straightforward how an investor should change his or her bond allocations to implement this type of strategy. The investor also has to consider any tax implications involved in this type of portfolio rebalancing, so beyond your investment adviser, you might want to bring in your accountant.

Which bond sectors do you think look attractive in today’s markets?

Follow me on Twitter: @drdonsays