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 will eventually need to increase short-term interest rates to manage inflation, Mr. Fox said a lot of investors are falling into a 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.”
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, Mr. Fox. said.