How To Overcome Your Fear Of Bonds

I specialize in building relatively conservative “all weather” style indexing portfolios. They are designed for people who have a reasonably long time horizon (at least 5-10 years), don’t want to go through another 2008, but also want to generate a decent return above the rate of inflation.

This means I end up managing a lot of fixed income because being a long only equity manager would expose my clients to too much 2008 risk and owning cash guarantees a negative inflation adjusted return. So bonds HAVE to fit into a multi-asset allocation.

This creates a whole different problem – most of my clients aren’t that comfortable with bonds, either because they don’t have much experience with them or have been trained to think that interest rates must rise (because they’re low) and that that means doom for bonds. But if you want to properly allocate your assets in a strategy that will sufficiently hedge against a 2008 style risk while also beating cash you virtually HAVE to get comfortable with bonds.¹ So here are a few tips on overcoming your fear of bonds:

1) Get your time horizon right and stop thinking so short-term! The best part of the bond market is that you know precisely what your time horizon should be. If you buy a 10 year bond and you judge it based on 10 month performance then you’re doing it all wrong. You buy the 10 year bond precisely because you can establish what your time horizon is and if you’re buying a high quality bond you know with a high degree of certainty that you will earn a consistent yield while getting your principal back at maturity. Short-termism is the biggest destroyer of behavioral alpha in the financial markets.

2) Get over your fear of “bond funds”. Many investors think there’s increased risk in a bond fund because it can’t be held to maturity like an individual bond, but a bond fund is nothing more than a portfolio of individual bonds. The key difference is that they have a “constant maturity” in most cases. This is a lot like a bond ladder in that the portfolio does have an average maturity, but it gets reinvested at higher or lower yields as parts of the portfolio mature over time. So, if you buy a bond fund with an average effective maturity of 10 years that’s a heckuva lot like owning an individual bond with a 10 year maturity. The key difference is that the bond fund diversifies out most of that single entity risk.