Mismanaged Bond Portfolios Are Costly

Fixed income investing used to be much easier.  An investor could clip 5% return in their sleep without taking much risk.  For example, from 1987 to 2000 the average U.S. 10-year Treasury yield was ~7% (virtually zero credit risk).

The current environment is a paradigm shift.  Aging baby boomers and investors need income, but it’s become much harder due to suppressed interest rates.  A fixed income investor can still generate a 5-7% return, but it’s through a CCC rated high yield bond (huge credit risk). 

As professional investors, we relish the creative challenge to generate a meaningful, yet risk appropriate returns in fixed income for Pure Portfolios clients.  Unfortunately, establishment firms and the advisors they employ are still using the same antiquated portfolio construction methods.  In our opinion, fixed income is the most mismanaged asset class within investor portfolios.  

Here are the most common advisor/investor mistakes:

Anchoring to the short duration trade due to the “rising rate environment”– Shorter maturity bonds have less sensitivity to upward interest rate movements.  An investor can reinvest a maturing bond at the new higher market rate.  Longer dated bond holders are stuck receiving lower interest for an extended period, thus missing out on higher coupon payments.  This has been the herd narrative from virtually every firm on Wall Street.  Being wrong happens to everyone, but being wrong for five years running is absurd.  Eventually, the herd will be right (even a broken clock is right twice per day), but in the interim, they’ve missed out on valuable income and solid returns for their clients in longer maturity bonds.

Paying your advisor to lose money– this one drives me crazy because it’s so egregious and avoidable.  Financial advisors that use short term (also called ultra-short) bond mutual funds are virtually guaranteeing their clients lose money.  Let’s run through an example:

Let’s assume we are paying XYZ Capital 1.25% per year to manage our portfolio.  Our advisor uses Wells Fargo Ultra-Short Income (SADIX) for a portion of our bond exposure (we could use any number of mutual funds, SADIX is just one example).  SADIX has an annual expense ratio of .35%.  Together, our annual cost of investing is 1.60%.  SADIX has a current yield of ~1.40%.  The investor is paying their advisor to lose money essentially locking in a loss of -.20% per year.  Absurd, right?  It’s more common than you think.   

Floating rate bondsFloating-rate(variable rate) loans are made by financial institutions to companies that are generally considered to have low credit quality.  As interest rates move higher, the floating-rate bonds coupon payments adjust up and the investor enjoys their new higher interest payment.  The problem is on the credit side…what happens when you increase the cost of capital/interest burden on a lower quality company?  Pro tip: it usually doesn’t end well.  

Aversion to individual bond purchases– most retail advisors lack the skill and expertise to evaluate individual bond issues for safety and soundness.  In our opinion, individual bonds are the best way to get exposure to investment grade bonds (corporate & municipal).  There is zero ongoing cost to own individual bonds and you always know what the payoff will be at maturity. If you have ~$500,000+ to invest in fixed income, do not let your advisor purchase bond mutual funds under the guise of diversification.

Fed can influence the short end of the yield curve, but not the long end– it’s a common misconception that higher Fed funds rate equals higher bond yields.  The Fed does have influence over short term interest rates and bond yields.  However, growth and inflation (oil prices, real wage growth) will determine longer term bond yields.  See our previous blog “What Actually Happens During a Fed Hike Cycle."

Fixed income is still the best way to mitigate risk within a diversified portfolio, however, investors should revise their future return expectations down due to historically low interest rates.  The way your bond portfolio is structured could be the difference between meaningful income or disaster. Enterprising investment professionals will use their skill to build efficient fixed income portfolios that reflect the paradigm shift of structurally lower interest rates/bond yields.  What does your bond portfolio say about your financial advisor?