3 common mistakes investors make with their bond portfolio

Bond investing is not easy, but avoiding the most commonly made mistakes can be. Matt explains.

When I talk to investors, both professionals as well as those who work outside finance, three mistakes seem to come up again and again when it comes to how bond portfolios are managed. Now I know what you are thinking: Matt, most people don’t go around talking about their bond portfolios. That’s true. But when I hear people talk about investing in general, I often hear at least one of these behavioral mistakes mentioned.

Mistake 1: Forgetting what your fixed income investment is for.

When you buy a bond or a bond fund, you need to answer a simple question: What role does fixed income play in your portfolio? The typical answers are: a) diversify equity risk, b) pursue income, or c) help protect principal. And, many investors look to their bonds to do more than one of these things. The right answer can vary depending on your age, income needs, risk tolerance, and a host of other factors. No matter what the answer is for you, stick to it. Don’t be tempted by the latest hot investment trend or what your neighbour is investing in. Stay the course; invest in a way that matches your investment goals.

One important caveat: In today’s market it can be difficult for your bonds to achieve any one of those goals above, let alone all three at once. The 10-year U.S. Treasury note is currently yielding 2.22% (as of  9/25/2017, source: Bloomberg), and while it provides diversification against equities, that’s not a lot of income. You can get over 5% on some high yield investments, but you may sacrifice some portfolio diversification and take on more return volatility. This was not always the case. Think back to 2006 when the federal funds target rate was at 5.25%. Back then a 3-month Treasury bill yielded 5% (source: Bloomberg). That’s income and low volatility. Today’s market doesn’t offer the same opportunities. So be precise with what you want your fixed income investment to do. Hold realistic expectations, and stick with your goal. Which brings me to….

Mistake 2: Making investments that don’t match your goals.

This may sound simple, but you would be amazed at how often people get this wrong. Let’s say, you are in retirement and have managed to build a nice nest egg. You want your bonds to help protect your principal, maybe provide a little income but mainly not lose much value. If that is your goal, emerging market (EM) debt may not be the right place to put a big chunk of your money. EM debt can be a great source of income potential in a diversified portfolio, but not when you are looking for low volatility. A short duration bond fund may be a better option.

A good way to avoid making this mistake is to pause after you have built your portfolio. Before you invest it, take another look and ask yourself a few questions: Did the investments you ended up selecting match your investment goals? Do they fit together well in the portfolio? This is a simple but invaluable step to make sure you stay on target with your goals.

Mistake 3: Abandoning bonds when interest rates rise.

Too often investors are tempted to act if their investments are falling in price. And typically when interest rates rise, prices of bonds and bond funds fall. The temptation to jump ship can be especially strong with exchanged traded funds (ETFs) because you can watch prices intraday, just like a stock. If this is your tendency, I would suggest you think about your long term goals when you check your portfolio. ETFs provide transparency and trading freedom, but that doesn’t mean you should trade and rebalance more frequently. Don’t let the availability of information distract you and steer you away from your plan.

And most importantly for your bond ETFs, know that rising interest rates may actually be good for long-term investors. You are probably thinking: Wait, what? How can that be if rising interest rates cause the prices of bonds to fall? Turns out this is how bond math works. When interest rates rise, the price of your fund at first drops. But then the fund begins to reinvest cash flows at the new higher yields, which would steadily boost income. Over time, this increased income can potentially offset the initial price decline. An intermediate fund with a duration of five years may recover price loss from rising interest rates in about five years. And after five years the fund may continue to be investing at higher yield levels, potentially resulting in higher returns. So if you are a long-term investor, you may actually want interest rates to rise.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a  contributor to The Blog in Canada.

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