Fixed-income investors focused on the direction of interest rates run the risk of making big mistakes, warns portfolio manager John Fox, co-head of fixed income at Gannett Welsh & Kotler LLC.
“Most investors are typically happy when rates are going down because they're seeing their bonds mark to market at a higher price,” he said. “But with the math of bonds, a big part of the return over time is interest on the interest.”
Mr. Fox, who manages $6.8 billion in municipal bond portfolios, said the most important thing bond investors should be paying attention to right now is the steepness of the bond yield curve and the width of the credit spreads between bonds of varying qualities.
Considering the popular prediction that the Federal Reserve Board will eventually need to start increasing short-term interest rates to manage inflation, Mr. Fox said a lot of investors are falling into a typical trap of migrating toward cash and short-term bonds for security.
“To me, the biggest mistake I see clients make is they want to be too short, and that's because they are defining risk by principal fluctuation,” he said, explaining that as a bond's rate or yield increases a bond's price goes down.
“The bigger risk is that rates keep going down, choking off the client's income stream,” he added. “There is a big information gap with regard to fixed-income investing.”
As evidence that a Fed tightening cycle doesn't automatically translate to higher rates across bonds of all durations, Mr. Fox cited the three-year period ended December 2006.
During that period, the Fed hiked rates in 17 separate 25-basis point increments, driving short-term rates from 1% to 5.25%.
“I think it's safe to say that most investors on Dec. 31, 2003, were worried about rates rising, and they did rise,” he said. “But it was short-term rates that rose dramatically and longer-term rates that either rose less dramatically or actually fell because the Fed exhibited enough credibility to convince the long end of the market that they were serious about fighting inflation.”
Mr. Fox, who believes in actively trading bonds to maintain diverse exposure to the full range of durations, warns investors against the “knee-jerk reaction to hide in cash or short-term bonds because of the supposed inevitability of rising rates.”
He chides financial advisers for trying to oversimplify the fixed-income portion of a client's portfolio.
“A lot of advisers are still saying you should go to short-term bonds if you're worried about rates rising,” he said. “Stringing together tactical decision after tactical decision is not a strategy.”
Diversity and flexibility are keys to getting the most out of a fixed-income portfolio, according to Mr. Fox.
“I'm not saying you should own all long-term bonds, but you definitely shouldn't own all short-term bonds,” he said. “If the financial crisis taught us anything, it's the value of diversification.”