Ten Mistakes that Most Bond Investors Make - dummies

Ten Mistakes that Most Bond Investors Make

By Russell Wild

Investing in bonds is easy. Investing well in bonds is hard. Bonds can be more complicated than they appear. It’s easy to get bamboozled, easy to make dumb mistakes. But if you watch out for these ten do’s and don’ts, you’ll be far ahead of the game.

Allowing the broker to churn you

Bond brokers generally make their money when you buy and sell bonds. They rarely make anything while the bonds are simply sitting in your account, collecting interest.

It rarely happens that a bond you were sold last year is no longer worth holding. Company was downgraded by the major ratings agencies? You probably already lost whatever money you’re likely to lose; selling the bond now will result in your locking in that loss. Why not hold the bond till maturity, if that was your original plan?

Interest rates have risen or fallen? Yeah, so? Don’t they always? Bond B has a more favorable tax status than Bond A? Well, why weren’t you told that when you bought Bond A?

You are almost always going to be better off as a buy-and-hold-till-maturity investor than you are riding the bond merry-go-round. If your broker calls with reasons to buy or sell, ask lots of questions and make sure you get clear answers as to why it is to your benefit, not his, to start trading.

Not taking advantage of TRACE

Buying and selling bonds is more transparent than ever before. That means that lots of information is available, if you know where to look. Until just a few years ago, a bond broker could charge you any kind of markup her heart desired, and you would have no idea what that markup was.

Now, with a system called TRACE (the Trade Reporting and Compliance Engine), you can go online and within moments find out how much your broker paid for the bonds she’s now offering to sell you. If you can’t, you can find out how much very similar bonds are selling for. Conversely, if your broker sells some bonds for you, you can find out how much she sold them for.

Choosing a bond fund based on short-term performance

A bond fund’s performance figures, especially going back for any period of less than, say, three years, can often look very impressive, but it may not mean squat. In most cases, a fund’s performance, especially over such a short time period, has more to do with the kind of bond fund it is than with any managerial prowess.

If, for example, high-yield bonds have had a great year, most high-yield bond funds — even the lousy ones — will see impressive performance. If foreign bonds have had a great year, foreign-bond funds will rally as a group. If interest rates have recently taken a nosedive, all bond funds will likely look good.

What matters most isn’t raw performance but performance in relation to other similar funds and performance over the very long haul — five, six years and beyond.

Not looking closely enough at a bond fund’s expenses

Bonds historically haven’t returned enough to warrant very high management expense ratios on bond funds. But that certainly hasn’t stopped some bond-fund managers from slapping on high fees. In the long run, the least expensive bond funds typically do the best. Don’t pay a lot for a bond fund. You don’t need to. The recent advent of exchange-traded funds has brought fund fees down dramatically.

Going through a middleman to buy treasuries

Through the U.S. government’s own website, TreasuryDirect, you can buy any and all kinds of Treasury bonds without paying any markup or fees whatsoever. You don’t need a broker. The website is easy to navigate, and everything (including the bond holding itself) is electronic.

Counting too much on high-yield bonds

High-yield (junk) bonds look sweet. Historically, they offer higher returns than other bonds. But the return on high-yield bonds is still much less than the return you can expect on stocks. It may not be worth the added risk of getting an extra couple of percentage points to hold high-yield bonds.

The main role of bonds in a portfolio is to provide ballast. That’s not to say that the interest payments from bonds aren’t important — they certainly are. But, above all, bonds should be there for you if your other investments, including stocks, have a bad year or few years.

Unfortunately, junk bonds don’t provide that ballast. When the economy sours and stocks sink, junk bonds typically sink right along with all your other investments. Investment-grade bonds, such as Treasuries, agency bonds, most munis, and high-quality corporates, usually hold their own and may even rise in value when the going gets rough.

Paying too much attention to the yield curve

At times, short-term bonds, even money market funds, yield as much as intermediate or long-term bonds. During these times, the yield curve is said to be flat. This entices many people to move their money from long-term to short-term bonds. In a way, it makes perfect sense. Why tie your money up and take the greater risk that comes with long-term bonds if you aren’t getting compensated for it?

But longer-term bonds still belong in your portfolio, even when the yield curve is flat — heck, even when the yield curve becomes inverted (meaning short-term bonds yield more than long-term bonds), as happens on rare occasion. Remember that the main job of bonds is to provide your portfolio some lift when most of your holdings are sagging.

If the economy hits the skids (hint: an inverted yield curve can be a sign of impending recession) and stocks suddenly plummet, chances are good that a lot of money will be funneled into long-term, high-quality bonds. Interest rates will drop; long-term, investment-grade bonds will soar; and you’ll wish you were there.

Buying bonds that are too complicated

Floating-rate bonds, reverse convertible bonds, catastrophe bonds, leveraged and inverse bond exchange-traded notes . . . many bonds and bond byproducts out there promise far more than simple interest. But in the end, many (if not most) investors who get involved wind up disappointed. Or crippled.

Keep it simple. Really. There’s no such thing as a free lunch, and any bond or bond package that promises to pay you more than plain vanilla bonds is doing so for a reason. Some risk is involved that you may not see unless you squint really hard — or until that risk pummels your savings.

Ignoring inflation and taxation

If you’re making 5 percent on your bonds, and you’re losing 3 percent to inflation, you’re about 2 percent ahead of the game . . . for a brief moment. But you’ll likely be taxed on the 5 percent.

Inflation and taxation can eat seriously into your bond interest payments. That’s not a reason not to invest in bonds. But when doing any kind of projections, counting your bond returns but ignoring inflation and taxation is like visiting Nome in winter and trying to ignore the snow.

Relying too heavily on bonds in retirement

An all-bond portfolio rarely if ever makes sense. Stocks offer a greater potential for long-term return and a better chance of staying ahead of inflation than bonds. They also tend to move in different cycles than bonds, providing delicious diversification. They help dampen volatility and smooth out a portfolio’s long-term returns, thereby potentially boosting long-term returns. Stocks and bonds complement each other like spaghetti and sauce.