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Piling into low-quality, higher-yielding bonds can diminish one of the primary benefits of a bond portfolio: offsetting equity volatility.

The balance between yield and diversification chartWith yields near historic lows across much of the fixed income market and the relative opportunity presented by both corporate and municipal high-yield debt, investors may be tempted to reach for additional income by tilting away from quality. However, while we believe that there is a place for high-yield debt in a diversified bond portfolio, moving too aggressively into lower-quality bonds can have unintended consequences.

High-quality fixed income traditionally serves as a portfolio ballast, as an income generator, and as effective diversifier to equity risk. Generally, high-quality bonds have typically very low or even negative correlations to equities. When equity prices are falling, high-quality bonds such as U.S. Treasuries or agency mortgage-backed securities will typically not only hold their value, but appreciate, reducing portfolio volatility.

Conversely, high-yield bonds not only exhibit greater volatility (and exposure to credit risk) than U.S. treasuries, but they also tend to be much more highly correlated with stocks. The result is that high-yield bonds often tend to fall in price and rally in conjunction with stocks, reducing their effectiveness as a counterbalance to equity risk.

Ultimately, investors must strike a balance between those competing goals (equity diversification and income generation). A measured allocation to high-yield bonds can be a valuable return enhancer but can’t replace the diversification benefits of core bonds.

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all of the information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis nonfactual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.

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