I have been going over some of the most common mistakes in bond investing and reminding investors not to forget the purpose of their fixed income investments. Building on that, today let us explore the curious blunder of investors making investments that don’t match their goals.
On the surface, this one sounds pretty silly. After all, if I have already figured out the role that I want bonds to play in my portfolio, can’t I just make an investment that aligns with that goal? The short answer is yes, but bond investing can be tricky. Sometimes the risks in the bond market are not well understood by investors. Other times investors lose sight of their goals as they begin to select their investments.
Reach (too hard) for income
In today’s low yield environment, some investors go off course because they’ve become too intently focused on reaching for income. With the 10-year Treasury yielding only 2.3% and yields in other asset classes low as well, there just isn’t a lot of income to be had (source: Bloomberg data as of 7/31/2017). To seek a yield of 4% or 5%, investors would have to consider the riskier parts of the market, like long-term corporate bonds, high yield and emerging markets. Yield is scarce, and can come with more risk than investors may realize.
Let’s imagine an investor, Billy, who is trying to preserve his principal with his fixed income portfolio. He has a one-year investment horizon, and then wants to use the money as a down payment for a house. His primary goal over the next year is to preserve his capital and it would be nice to receive a little income along the way. What kind of yield might Billy get from a 1-year Treasury bill? The 1-year Treasury bill is yielding 1.19%, which isn’t a lot. He may be tempted to take on more risk to get what is perceived as a more reasonable level of yield. Here are some options, ordered by yield potential:
Yield and risk at a glance
Seeking a 2% yield? Billy could consider a 6-year Treasury note. 3%? Even a 30-year Treasury Bond is only yielding 2.90%, which means he would need to consider corporate bonds. 4% or more? Billy would have to look to riskier sectors of the market like long maturity bonds, emerging market debt or high yield, and they do not fit with his primary goal of capital preservation.
To help investors think about the risk of each investment, I added a couple of columns to the table above. As we have discussed before, the two most common risks in fixed income are interest rate risk and credit risk, which each investment is exposed to at different levels. Moving to longer maturity Treasuries may offer more yield potential than a 1-year Treasury, but it also means taking on more and more interest rate risk as you move out the curve. We see the same thing with credit risk; higher levels of risk offer higher levels of yield potential.
The combination of a one-year time horizon and the goal of principal protection does not leave much room for Billy to take on interest rate or credit risk. Staying in T-bills, a generally low risk money market vehicle, or a short duration fund might make sense.
Not as diversified as you think
Let’s look at another hypothetical example: Betty has diversification as a goal for her fixed income investment, and wouldn’t mind some income along the way. If you remember my last post, the income and diversification objectives pair well together. There are many investments to choose from—intermediate and long-term Treasuries, or investment grade and longer maturity corporate bonds—to help meet both goals.
But again, what if Betty still wants more yield and is tempted by the high yield market? It does offer a medium level of interest rate risk, which is consistent with the diversification objective. The problem? Credit risk has been positively correlated with the equity market. Adding too much credit risk to a portfolio could undermine the goal of diversification. In fact, the correlation between the equity (represented by the S&P 500) and high yield (represented by Bloomberg Barclays High Yield Index) markets over the past 10 years is 0.73, which points to a strong relationship (source: Bloomberg data as of 7/31/2017). Put simply, high yield bonds might not provide sufficient diversification against equity market risk. Betty may want to consider investments that have medium to high levels of interest rate risk, and low to medium levels of credit risk.
Picking the bonds that align with your investment objectives can indeed be harder than it seems. I hope calling out some of these potential pitfalls will make it easier for investors to remember their goals and focus on the right investments. Next time, I will talk about another often seen misstep, abandoning bonds when interest rates go up—and the puzzling mystery of why the rise might actually be good for bond investors.
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