Buying bonds is all the rage right now and with good reason, for the last 15 years the Federal Reserve has kept central bank rates at near zero percent which meant bonds and savings account paid nearly zero percent. Many banks take advantage of their customers and offer a paltry 0.01% interest because most people won’t bother to move their money around. Well, that’s not a problem with me, I have been buying bonds like it’s the end of the world and I’ll tell you what I’m buying but first a word from our AI companion on key bond buying mistakes.
Ignoring Interest Rate Risk: Bond prices move inversely to interest rates. If interest rates rise, bond prices typically fall. Many investors don’t account for this, especially when investing in long-duration bonds.
Overlooking Credit Risk: Not all bonds are created equal. Investing in bonds with a higher yield without considering the issuer’s creditworthiness can lead to potential defaults.
Chasing Yield: In the pursuit of higher returns, some investors might take on more risk than they can handle by investing in junk bonds or those with lower credit ratings.
Lack of Diversification: Just like with stocks, it’s essential to diversify bond investments across different sectors, maturities, and credit qualities to reduce risk.
Not Understanding Callable Bonds: Some bonds can be “called” or repaid by the issuer before their maturity date. If interest rates drop, an issuer might call a bond, and the investor might have to reinvest at lower rates.
Ignoring Inflation Risk: Fixed-rate bonds can lose purchasing power over time if inflation rates exceed the bond’s yield.
Overestimating Tax Advantages: While municipal bonds offer tax-free interest, their yields might be lower than taxable bonds. It’s crucial to compare the after-tax yields of different bonds.
Neglecting Fees and Costs: Some bond funds or brokered bonds come with fees and costs that can eat into returns. It’s essential to be aware of these and factor them into your investment decision.
Holding Until Maturity Fallacy: Some believe that holding a bond until maturity eliminates interest rate risk. While you’ll get the face value back at maturity, the opportunity cost of not reallocating to higher-yielding bonds when rates rise can be significant.
Misunderstanding Bond Ladders: Creating a bond ladder involves buying bonds with different maturity dates. While this strategy can help manage interest rate risk, it’s essential to ensure that the maturities align with your liquidity needs.
Over reliance on Ratings: While credit rating agencies provide a guideline, they aren’t infallible. It’s essential to do independent research and not solely rely on ratings when evaluating bonds.
Failing to Rebalance: As interest rates and market conditions change, the composition of a bond portfolio might drift from its target allocation. Regularly rebalancing can help manage risk and maintain the desired portfolio structure.
By being aware of these common pitfalls and conducting thorough research, investors can make more informed decisions and optimize their bond investments.
So what does my diversified bond portfolio look like right now?
- 50% 30 day T-Bills
- 5% 1 & 2 Year T-Bills
- 5% 5 year TIPS
- 5% 20 year US Treasury Bonds
- 5% TLT (20 Year Bond ETF)
- 3% GSE Bonds (Paying 7% interest but are callable)
- 68% Cash (Paying 5% in cash account)
If you are wondering why I have so much cash right now it is because I expect bond yields to continue to climb but if I’m wrong I am starting to accumulate some bonds in different time frames. I also hold some very small positions in municipal bond ETFs but I am waiting a little longer to buy more.