4 Things to Know About Bond Investing

One question that everyone has been asking lately—“When is the Fed going to raise interest rates?” While this is certainly the question of the hour, for long-term investors, it is likely irrelevant to the construction of a bond portfolio that has an emphasis on quality investments. Here are 4 things that, long-term fixed income investors, should pay focus on.
1.) Understand the bond’s role in a portfolio
As far as bond portfolio management goes, many investors, (especially retirees) are focused solely on generating income. However, it’s important for investors to be aware of the risks that are taken to achieve a set income in today’s low-interest rate market. When interest rates are low (and bond prices are high), the income approach might influence investors to purchase more bonds, extend their current holding’s duration, or even accept lower credit quality in order to maintain a specific level of income.
Perhaps a better approach would be to decouple cash flow decisions from income decisions. To do this, investors need to set a rational asset allocation and then periodically rebalance to this goal. Be sure to determine a monthly withdrawal rate that satisfies a client’s living expenses, and then determine some combination of interest, dividends, and proceeds from any maturities and sales that will provide enough cash to meet this withdrawal each month. Perhaps most importantly, if there isn’t enough yield during a month to meet this withdrawal rate, the factor that determines whether investors should sell bonds or equities to offset this shortfall will be their asset allocation. If equities are soaring, they should be trimmed back to the baseline to generate cash, if equities are down, reinvested interest and proceeds from maturation of bonds should be used instead of being forced to sell stocks at an improper time.
Not only does this allow a bond portfolio to provide stability to the overall portfolio’s value, but it also ensures that the portfolio will have the ability to invest in equities in the event of a broad market sell-off just by rebalancing to the target asset allocation. This method helps investors to sell high when the prices are up, and rates are low as well as buy low when prices are low and rates are high. Most importantly, by maintaining a disciplined approach to rebalancing keeps an investor from panicking during times of market stress.
2.) Keep it Simple
Bonds are not rocket science. The majority of investors will be pleased by using a simple bond ladder- it’s the easiest to understand, the lowest cost, and might be the safest way to invest. By buying bonds with laddered maturities and starting at one year, going out to about 8-10 years, a bond portfolio becomes fairly insensitive to whether interest rates are on the rise or fall. If rates rise, the proceeds from mature bonds every year can then be used to purchase bonds at the new higher rates at the end of the ladder. If rates fall, the bonds that mature in the next year or two may have to be invested at a lower rate, but the majority of the portfolio would still consist of bonds purchased previously with higher yields. Interestingly enough, the investors that are hurt the most by the current low rate environment were the investors that thought they were being conservative by buying short-term instruments in 2007 or so. Since the Fed lowered short-term interest rates to near zero, most of these investors saw income plunge by 75% or more within a couple of years.
3.) Don’t over emphasize liquidity
The majority of investors are not concerned about liquidity most of the time. Sadly, when liquidity is needed, it’s a time when some bonds will likely become illiquid. This is a lesson that investors who attempted to sell long-term or lower credit quality bonds in 2008 and 2009 learned all too well
Most clients can mitigate the effects of these occasional liquidity crises by investing in taxable accounts and by sticking to only high quality short and intermediate bonds.
4.) Don’t Forget Individual Bonds
There has been much written about the benefits of buying individual bonds rather than investing in bond funds or ETFs. Looking at the numbers, having a portfolio of individual bonds should perform similarly to investing in a bond fund that possesses much of the same duration and credit quality. However, there are two distinct psychological advantages with having holdings in individual bonds over investing in bond funds.
The first advantage is best discussed in anecdote:
In the early to mid 90’s, there was an interesting thing that happened when rates climbed higher than 2.5% during October 1993 all the way into November 1994. The average investor in both individual bonds and bond funds lost approximately the same amount of money in this period, but they had vastly different reactions. Individual bond holders retained their investment—they knew that they would recover 100 cents to the dollar on the bonds if they just stayed put until maturation (save for situations where the bond defaults). Other investors weren’t as calm—those that had invested in bond funds panicked as they watched the net asset value of these bond funds dropped—the unrealized market value losses quickly became realized within the fund as other investors cashed in.
There is a second advantage with holding ownership of individual bonds—an investor can know what they own. A bond fund’s average credit quality leaves out the details—you’ll have to read the fine print in a prospectus to know if a fund has 15% of assets in Puerto Rican bonds, whether it holds ownership in derivatives, or whether it is leveraged or not. Investors that believe that the primary purpose of their fixed income investments is safety will take solace in having access to the information so that they can see if their bond portfolio reflects that goal. Many bond funds lack immediate transparency—complicating matters. This can lead to investor unease if the market experiences a dip.
To put it simply—it doesn’t matter if interest rates are rising or falling, owners of individual bonds are more likely to weather the course and not react irrationally (and potentially harmful) based on a short-term dip in market conditions.