If you’re like most people, you probably have a part of your retirement savings (and other assets) allocated in bond mutual funds. And if you’re like most people, you probably put together an allocation and forgot about it – the “set it and forget it” strategy.
Investors like to diversify into bonds to reduce the overall risk of their portfolio, which can make a lot of sense. However, you have to remember that there’s a big difference between individual bonds and bond mutual funds, and that there are important risks you need to take into account if you invest in bond funds.
Individual Bonds versus Bond Mutual Funds
When you invest in an individual bond, you have complete transparency on the bond’s duration, interest rate, and credit rating. You know that even if the price of the bond falls, you’ll continue to get your interest coupon. This can provide an important steadying influence on your overall portfolio, especially if you’ve invested aggressively on the equity side (presuming the bond does not default). You also have the luxury of waiting for the bond to mature, meaning you get paid out at par in spite of any price changes in the interim.
Bond mutual funds, on the other hand, are pooled holdings of many bonds. Because these funds want to deliver returns to their investors, they might include lower-quality holdings in the portfolio or use leverage to enhance returns. Some funds also pursue investments in longer duration bonds in order to chase higher interest rates, especially at a time like now, when interest rates are still low. These actions expose the portfolio to additional risks which most investors don’t know about or take into account. I call it “chasing yield.” This may have been a good strategy in the past, or even currently. However, if and when yields rise it won’t seem like such a good idea, if your principal starts to fall.
But I Can’t Afford Individual Bonds!
Many investors can’t invest in individual bonds in their 401(k) and 403(b) accounts regardless of how much money they have. In this case, I advise that you take a close look at your bond mutual funds and make sure of the following:
– The funds you are invested in do NOT employ leverage
– The holdings are of a high credit quality that you are comfortable with
– The holdings are of short to medium duration
If you’re using bond funds to reduce the risk in your portfolio, you’ll want to focus on high credit quality and short to medium duration. These bonds will have lower risk in terms of defaults and in terms of interest rate changes. Why? Well, credit quality speaks to the quality of the borrower and the likelihood that they’ll default. To reduce risk in a portfolio, you’ll want better quality borrowers! As for duration, it’s an important part of fixed income investing because bond prices tend to fall as interest rates rise. The bonds that are most affected by these price movements are longer-term, or long duration.
You’ll also want to avoid leverage at all costs. While it can be very tempting to invest in a bond fund that produces levered returns, it’s important to remember that in times of instability they may perform very badly, and it’s precisely in those times that a secure bond allocation makes itself useful.
Understand that taking these steps will produce less yield, which may be frustrating, but if interest rates rise, your principal should not decrease as much. At that point, I promise you won’t find it frustrating at all!
Don’t Get Greedy
One of the biggest pieces of advice I give my clients when investing in bonds is to stop chasing yield. Bonds are a great part of a diversified portfolio because they provide income and a steadier source of returns than equities. Chasing yield through low credit quality, long duration, and leverage are a surefire way to introduce unnecessary risk to your portfolio. Unless you are really sure of what you’re doing and it’s part of an overall strategy developed with your advisor, leave the speculation to the institutional investors.
Revisit Your Allocation
One of the most important pieces of advice I can give is to remember to revisit your allocation. Don’t just set it and forget it, as this is a recipe for a stagnant portfolio that doesn’t adjust to your changing needs and changing economic conditions. For this reason, if you can, I advise employing actively managed individual bond portfolios for this reason. In this scenario, you own the bonds directly rather than investing in a bond mutual fund, which I believe is preferable.
However, no matter what you invest in, there is still no replacement for regularly revisiting your investment strategy. Click here for a previous article I wrote explaining the importance of active bond management.
Get the Help You Need
Bond mutual funds can be a great way to diversify your retirement savings, but it’s important to know what you’re investing in and to avoid chasing returns. Don’t be afraid to ask your advisor for help understanding your investments. Remember, these are your hard-earned assets, and whether it’s retirement savings or other savings, it’s worth taking the time to ensure that your portfolio strategy is appropriate for your risk level!
While interest rates might not be going up in the very near future, I do expect to see them rise over the next few years. Because the market is anticipatory, this means bond prices will begin to shift ahead of interest rates. There is no time like the present to take a look at your investments and ensure that your strategy is being carried out appropriately. I’ve written about this in the past, and though I was ahead of the trend at the time, the lessons of preparing your portfolio for a recovery are the same. Click here to learn more!
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photo credit: sea turtle via photopin cc
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Written by Bradford Pine
Bradford Pine Wealth Group – New York City Financial Advisors
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[…] in February, prior to rates going higher, I wrote a Warning article about precisely this issue and how to approach bond investing with future yield hikes in […]