Investors have been sending torrents of money to bond funds over the past two years, and I'm worried. With the threat of rising interest rates looming over the bond market, I'm concerned that fixed-income investors seeking the same kind of fairly safe and stable 6% annualised returns they've earned over the past decade will be sorely disappointed in the next one. So rather than compiling a 'To Do' list, I've created a 'Not To Do' list to help you avoid making some key mistakes as you position your bond portfolio.
Don't Get Hung Up on Current Income
This article has "income-focused investors" in its headline, but let's back up a minute. Is it even healthy to focus on generating income, particularly if doing so comes at the expense of total return? Is generating a livable yield from a portfolio a vestige of a bygone era? No and yes, I'd say.
It's easy to see the intuitive appeal of being able to live on the income you earn from clipping bond coupons, yet being too income-focused carries its own set of pitfalls. A key one in today's low-yield environment is that you have to venture into very risky stuff to generate a livable yield, and that could erode your principal in the process. And by focusing unduly on investments that kick off income, you also risk starving your portfolio of the capital-appreciation potential that comes with stocks. True, stock returns have been no great shakes over the past decade, but bonds may well fight their own uphill battle over the next one.
The bottom line is that most people will have to tap their principal to fund living expenses in retirement, so the key aim for most retirees and pre-retirees should be to grow those retirement kitties as large as they can. If they have to tap their principal, they'll be tapping a larger base than if they had focused on income without regard to total return. Investments that generate current income aren't bad, but total return is your real bottom line.
Don't Spend Too Much Time Looking for the Licence Plate on the Car That Just Hit You
With concern over bonds flaring up, investors have a natural tendency to look backward in an effort to identify where trouble could lurk in the future. However, it's a mistake to spend too much time looking to the 2008 bear market for clues about which bond types could suffer going forward.
Bear markets, like Tolstoy's unhappy families, are all different. The bonds and bond funds hardest-hit in the past crisis--lower-quality securities--would likely hold up better than higher-quality securities in a rising interest-rate environment. For a view of how a fixed-income investment is apt to behave in a period of rising interest rates, the years 1999 and 1994 provide the best lenses in recent history. Duration, a measure of interest-rate sensitivity, also provides a good forward-looking gauge of how an investment would behave in a period of rising rates. Morningstar's Eric Jacobson delves into duration and what it can tell you in this article.
Cash Is Cash
I haven't surveyed a broad swath of investors about why they're buying bonds, but I'm guessing most fall into one of two camps. In one camp are investors who would rather settle for a low--but knowable--return via bonds than they would endure a repeat of 2008's stock-market crash. In the other camp are investors who are frustrated with the minuscule to nonexistent yields they're earning on their cash. I have issues with those swapping stocks for bonds right now, to be sure, but I also worry that those looking to bonds as a higher-yielding cash substitute will be disappointed.
Low cash yields argue for not holding more in cash than you need for your emergency fund or, if you're retired, to cover at least two years' worth of living expenses. But once you've arrived at an appropriate cash target, sit tight in true cash rather than venturing into higher-yielding, but also higher-risk, fixed-income alternatives. If and when rates head up, you'll be able to swap into a higher-yielding alternative (or your money market manager will), and you'll be glad you didn't over-reach for yield.
Don't Overestimate Your Crystal Ball
Yes, it's conventional wisdom that interest rates will head up in the future; they certainly don't have a lot of room to move down. At the same time, it's a mistake to position your fixed-income portfolio for that scenario and that scenario alone by moving your fixed-income investments to cash, perhaps, or completely avoiding gilt-edged securities, which tend to be more rate-sensitive than corporate bonds.
It's not unreasonable at this point to scale back your portfolio's exposure to highly rate-sensitive bond investments, such as long-term gilts, but you also want to leave room for other scenarios to play out. In a geopolitical shock of some kind, for example, good old government bonds would likely hold up better than anything else. Diversification, as always, is the name of the game.
Don't Believe Expensive Active Managers Will Continue to Earn Their Keep
Investors often defend high-priced fund managers, arguing that they've "earned their keep." Some certainly have, outperforming managers of lower-cost funds or ultracheap index funds. But what has been true in the past may not always be so in the future, particularly in a less forgiving fixed-income investing environment.
Low expenses are one of the best predictors of whether a fund will be a good performer in the future--especially for high-quality bond funds, where the range of returns within a given category tend to be bunched closely together. Low costs are certainly far more predictive than past returns. And think about it. If you'll be lucky to earn 5% on your fixed-income investments over the next decade, do you really want to cede a whole 20% of your return to fund-management costs? That's what you're doing if you buy a fund with a 1% expense ratio that subsequently earns just 5% per annum.
Don't Go Overboard with Non-Sterling Exposure
Worries about the UK deficit and the prospect of declining long-term economic growth have prompted some pundits to suggest that non-sterling-denominated bonds will be the place to be in the months and years ahead.
I'd agree that foreign bonds are yet another source of diversification for fixed-income portfolios, but it's a mistake to get carried away and fully supplant your UK bonds with non-sterling exposure. For one thing, currency movements are a big component of the returns that investors receive from foreign bonds and foreign bond funds, but those movements are notoriously hard to predict, as I argued in this article.
And if you're retired and looking to your fixed-income portfolio to stabilise riskier investments that you hold, such as stocks, adding non-sterling exposure introduces an element of unwelcome uncertainty. If you add unhedged foreign bonds or bond funds to your portfolio, think of it as just a small sleeve of your fixed-income portfolio.
One other reasonable way to obtain non-sterling exposure is to invest a relatively small slice of your bond portfolio to a multisector fund that invests overseas.
A version of this article was originally published in April 2010.
