Potential Pitfalls In Bond Investing
Last year around this time I published an article, Potential Pitfalls In Bond Investing. What followed was the worst year for bonds in decades. I’d like to think I timed the article perfectly, but it was more a coincidence than anything. I watched over the years as the bond market composition changed dramatically, particularly the average maturity of bonds increasing by over 50% from 4 years to 6+ years in the past decade. This resulted in a painful year for passive bond owners this year as long-term bonds got hammered. I wanted to reshare the post because the principles still apply as you consider how to invest in bonds going forward.
Potential Pitfalls In Bond Investing (Original Post: December 6th, 2021)
Clients of mine know that we tilt heavily toward low-cost broadly diversified index funds to build portfolios. This has historically produced far better returns than using higher-fee active fund managers to try to outperform the market. However, there are a few areas of the market where we believe good active managers can outperform the index simply due to the flaws in how that index is made. One of those indexes is the bond market.
The Barclays Bond Aggregate Index is an index made up of different types of bonds – US Treasury Bonds, Corporate Bonds (i.e debt issued by Mcdonalds or Microsoft), agency debt (i.e Fannie Mae), and others. The weight that each gets depends on how big each component is to the larger debt universe.
Because of the way in which that index is made, there are three pitfalls to consider before allocating your entire bond allocation to the aggregate index.
(1) Fiscal policy has dramatically shifted the weightings – Because the index is weighted based on how much of each debt exists, the percentage allocated to US Treasury bonds has increased significantly due to the heavy borrowing our government has done. While US Treasury’s could make sense to own due to their low-risk diversifying benefits, it has become the bulk of the index.
(2) The index captures less than half of the bond market – The way in which the bond market index is comprised excludes large components of the debt universe. In fact, there are certain types of debt that are completely ignored. For example, in taxable accounts it might make sense to own tax-free municipal bonds. For shorter term funds, you might want to add some to low duration high-yield bonds. You won’t find either of those in the index.
(3) The maturity dates for the bonds are too far away – One of the risks to manage in bonds is “duration risk.” This is the risk your bonds will fall in price if interest rates rise. Imagine buying a 30-year Treasury yielding 2%. The next day, interest rates go up to 3%. The price of your bond is going to fall dramatically because who wants 2% for the next 30 YEARS when they can get 3%? In fact, all else equal, your bond will likely fall by 30% (1% for each year until maturity).
When interest rates are low, like they are now, it is important to manage your duration risk. One of the best ways to do this is to buy bonds that come due sooner so that if rates rise, you get your money back quickly and can reinvest at higher rates. With this in mind, take a look at how the duration of the bond market index has increased over the 10+ years.
Despite these three pitfalls of the index, I still believe it is okay for the index to be a part of an investors bond allocation. It provides a low-cost way to get exposure to some of the largest high-quality bonds in the debt universe. But proceed with caution – there is a lot more out there to consider.
Thank you for reading,
Alex
This blog post is not advice. Please read disclaimers.