We are about halfway through the year and a trend I have encountered when meeting with potential clients is a significant issue with their asset allocation. Whether managing on their own or with the help of a professional, investors are having a hard time pulling together an appropriate bond portfolio. Here are some of the most common mistakes when investing in bonds.
Forgetting why you have bonds in the first place
It is easy to forget about bonds; they are never in the news and most people can’t even name a common bond index. We have all heard of the Dow Jones Industrial Average or the S&P 500 but when is the last time you have had a rousing conversation about the Bloomberg Barclays US Aggregate? Bonds are not sexy but that is the point, they are consistent and largely more predictable.
Bonds are in your portfolio for three main reasons: to diversify risk, provide income, and protect principal. The amount you need depends on your circumstance but bonds most often create the core of an investment portfolio, especially for retirees. Their stability gives investors the chance to take a predictable draw in retirement and not be subject to the up and down nature of the stock market.
Mistaking all bonds as being the same
The bond world is both deep and wide. The US bond market is near twice the size of the US stock market and bonds can come in all kinds of varieties just like stocks. Intuitively we know that some stocks are riskier than others, buying shares in a smaller startup is riskier than buying shares in General Electric. While that may seem obvious, many investors including professionals seem to forget that fact when it comes to bonds.
One of the most common mistakes we see is investors abandoning core bond strategies and reaching into riskier and riskier markets. Sectors like high yield, floating rate, and emerging market bonds are great but should only be a small portion of your bond portfolio because in the end they often behave more like stocks than your typical bonds. They may return more and generate more income but they fail to diversify risk and protect principal which is part of the essential roles bonds are supposed to play.
Abandoning bonds because of rising rates
The justification we get for these modified bond portfolios is typically something similar, why own bonds when we know rates are going to rise? There are a few things to remember here. First is that interest rates are important but they are just one of many factors. For example, in 2016 rates went up significantly for the first time since the financial crisis and bonds overall were still positive. In fact, the high yield space was even up double digits.
Another thing to think about is if not bonds, then what? The most common replacements are riskier bonds, stocks, REITs, and cash. Cash earns virtually nothing, will not keep with inflation, and for most guarantees failure in retirement which I would argue is far more dangerous to hold over the long term. Riskier bonds tend to act more like the stock market as discussed above. The stock market is significantly more volatile and is far more likely to impact retirement goals and put principal at risk. REITs are often confused because they produce income like bonds but in the end, are often even more volatile than the stock market because they employ leverage and ironically are usually more exposed to changes in interest rates.
Abandoning bonds because of interest rates and then moving to these riskier assets is much like saying I no longer want to use the sidewalk because I am nervous about people on bicycles so I will walk on the freeway shoulder instead. It is true that you may have reduced some of your risk of bicycles but instead have massively increased your overall risk profile. Having a solid core bond portfolio is essential to portfolio construction especially in the later stages of a market cycle. Bonds can be tricky but the most important thing to remember is why you own them to begin with and then sticking with your strategy over the long term.