06/11/2013 01:05 pm ET Updated Aug 11, 2013

Diversification Through Fixed Income

By Linda Descano, CFA President & CEO, Women & Co.

For most of us, the word "bonds" brings to mind a savings bond that family members (or friends of the family) may have given us when we were born. But in reality, bonds can be an important component of a well-diversified portfolio.

Bonds and other fixed-income securities are a tool to help manage volatility in a portfolio. They can also serve as a buffer during prolonged periods of low stock market returns. Why? It's a question of correlation.

Stock and bonds tend to respond differently to changing economic conditions -- their returns tend to follow different patterns over time. For example, returns on bonds, particularly U. S. Treasury bonds, may hold up better during periods of recession. Stocks, on the other hand, often outperform when economic growth is rapid or inflationary pressures are rising.

Historically, returns on stocks and bonds have tended to have a relatively low correlation. Stocks as an asset class historically have generated higher long-term returns than bonds(1). But, bonds have the benefit of relatively lower volatility. This gives most investors a strong incentive to include a fixed-income component in their portfolios. Combining equities with fixed income assets may potentially lead to better investment performance over the long run.

Similarly, diversifying your fixed-income investments may help improve your long-term performance. There is a vast array of fixed-income investments. They are classified into different market sectors based on the type of issuer, the credit quality, and/or the source of the cash flows used to pay principal and interest. Some well-known sectors are Treasuries, municipals, asset-backed, and corporates. Like stocks, all fixed-income investments carry risk, even though, as in the case of short-term Treasury Bills, the risks are so small they could be considered almost negligible. The risks as well as the potential returns of bonds can vary widely from sector to sector and even within a sector. Just as with any other type of investment: the greater the reward, the greater the risk.

It's important to discuss tax consequences with your investment advisor when considering fixed-income investments. Some bond categories offer particular tax advantages, at least for some investors. Interest on most municipal bonds, for example, is exempt from federal income tax, while interest on Treasury securities is exempt from state and local income taxes. For these reasons, you may also want to involve your tax professional in discussions with you and your financial professional when considering potential fixed-income opportunities.

There is a vast universe of fixed-income investments and specific features to consider when evaluating a bond. Discuss the potential role of bonds in your portfolio with your financial professional.

1. Standard & Poors, 2010.

Women & Co., a service of Citi, is the go-to personal finance source for women. By providing financial content, commentary and community, Women & Co.'s mission is to get women thinking and talking about personal finance. Founded in 2000, Women & Co. is one of the longest running personal finance websites dedicated to helping women strengthen their financial futures.