Floating rate bonds a fine choice to diversify portfolio

A lot of smart folks advocate the Noah’s Ark approach to diversification. Buy two of everything in the hope of getting the broadest possible diversification. Throw in bonds, cash, stocks, hard assets and the kitchen sink. Though we don’t have a lot of experience with floating rate bonds, the structure of these bonds makes them a fine choice of those looking to diversify a portfolio of financial assets, and particularly stocks. Floating rate bonds should hold their own in recession. Meanwhile, like hard assets, these bonds will rise in value along with increases in consumer prices. In fact, you are guaranteed to outpace inflation with floating rate bonds. Hard assets, by contrast, come with no such guarantee and the short-run performance can be entirely fickle.

If you purchase floating rate bonds, the principle value of your bonds is stepped up each year, along with possibly the prime lending rate or some other related basis or index which is linked to inflation. If inflation runs at 3 percent a year between now and the bond’s maturity date, the value of your floating rate bonds  will get boosted at this rate. The interest payments kicked off by the bonds will also rise along with inflation. If the interest rate on the bonds is 3.5 percent, every year you will receive interest equal to 3.5 percent of the bond’s growing principal value. Cash investments, such as Treasury bills, bankers’ acceptances, commercial paper and money-market funds, also offer a fine way to fend off short-term inflationary bursts. By definition, these investments mature within less than a year. Money-market funds, for instance, are required to own debt instruments that, on average, have less than 90 days to maturity. With a money-market fund, you shouldn’t ever find yourself locked into a lousy yield relative to inflation, because you are never locking in a yield.

Your money-market fund’s investments should  mature constantly and get replaced by new securities. The yield on these new securities will reflect prevailing concerns about inflation (or the lack thereof), so that your money-market fund earns returns close to or somewhat ahead of inflation. This isn’t the stuff that fortunes are made of. But it does provide dependable ballast for a stock portfolio, which great fortunes are made of. Cash and floating rate bonds won’t give you the sort of explosive, eye-popping returns that you might get with hard assets, especially gold. When inflation heats up and most stocks and bonds get decimated, gold can soar, providing the sort of exaggerated gains that can help a sagging portfolio. The problem is, these gains aren’t reliable. By contrast, you can be confident that cash and floating rate bonds — while they won’t go through the roof — will post decent results during an inflationary spurt. They offer what you want from hard assets, but don’t get — reliable portfolio protection.