Mistakes Bond Investors Make, Part 1

“Prudent investors never invest in any security unless they fully understand the nature of all the risks.” – Larry Swedroe.

Over the many years that I have advised investors, I have spoken to a number of people about bonds. The conversation was very different depending on the environment at the time. In 1999, for example, when common stocks were on a tear, I had to explain why anyone would invest anything in bonds. Interestingly, in recent times, I’ve had to talk investors out of investing too much money in bonds.

These are both examples of what Behavioral Economists call “recency.” We tend to place more emphasis (and trust) on more recent data and ignore older data, even if it is more comprehensive.

A more general problem is that investors do not understand the role that bonds should play in an investment portfolio. When you buy a bond you are essentially lending money to an organization, whether it’s a corporation, a state, or a country. In exchange for your “loan,” you are promised a regular payment, usually on a semi-annual basis, plus the full amount of the money you “loaned” returned to you at a given date. Depending on the circumstances, you may or may not realize the promised returns. You should also know that bonds do not reward you for any growth in the economy.

Most serious portfolio strategists view bonds as a way to provide stability to a portfolio. Accordingly, this approach argues for only buying very high quality bonds. The reasoning is that you won’t want a bad economy to affect both your stock portfolio and your bond portfolio at the same time. The whole idea is that, when economic times are bad, bonds should provide a safer haven than stocks.

Investors who mistakenly try to enhance their returns by buying low-grade “junk” bonds can end up doing just the opposite.

Larry Swedroe is the author of several books on investing, including one he co-wrote with Joseph Hempen The Only Guide to a Winning Bond Strategy You’ll Ever Need.

In a recent blog post, Junk Bonds Are Just That – Junk, Swedroe uses Morningstar data to illustrate just how badly some junk bond funds did in 2008. The same conclusions would be reached if considering individual low quality bonds.

Glancing at his tables is very instructive.

Investors who “stretched for yield paid a severe price.”

Losses on the 10 worst taxable bond funds and the three worst municipal bond funds were all worse than the 37 percent loss of the S&P 500 Index in 2008.

There are two lessons you should learn from the experience of 2008. The first is to never confuse yield with return. The second is that credit risk is correlated to equity risk. When the risks to equities shows up, credit risk tends to rear its ugly head at the same time. Thus, credit risk and equity risk don’t mix well together in a portfolio.

Conclusion

I agree with Swedroe’s recommendation of limiting fixed income investments to only the highest quality issues. On the other hand, I believe that it is a mistake for investors to overemphasize bonds in a portfolio, now that stock prices have declined so much. This is akin to locking the barn door after the horses have left.

In the long-term, you need both equity investments for growth and bond investments for stability. How you make that allocation decision is the most important determination of how your portfolio will behave in the future.

To be continued.