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4 Mistakes Bond Investors Should Avoid When Rates Rise

Rebecca Lake

A strengthening economy typically means more jobs and moderate adjustments to the inflation rate but it also opens the door to something else: rising interest rates.

Following a 0.25 percent rate hike in December 2016, the Federal Reserve recently announced another rate increase, moving the key borrowing rate to a range of 0.75 to 1 percent. That's significant for investors who have sizable bond holdings.

Rising interest rates generally correlate to a drop in bond prices. While the recent quarter-point increase may not have a drastic affect on the returns of your current bond holdings, future rate hikes could prove more impactful. With additional rate increases likely, there are some potentially costly missteps to avoid when managing bond investments.

Refrain from generalizations. Bonds aren't all the same and it's important to keep that in mind as rates rise.

"One of the most common mistakes bond investors need to avoid is assuming all bonds react equally negatively to higher rates," says Karissa McDonough, chief fixed income strategist at People's United Wealth Management in Burlington, Vermont. "There are very different segments of the bond market and a variety of ways to position in a rising rate environment."

[See: The 9 Best Municipal Bond Funds for Tax-Free Income.]

McDonough says making blanket assumptions about bonds when interest rates are on the move may lead some investors to exit the asset class prematurely. In doing so, they're discounting the important role bonds play in smoothing overall investment portfolio volatility.

Larry Kallevig, owner of Minneapolis-based Haven Financial Group, says investors also need to understand the differences between various bond types as they add new bonds to their portfolios.

"Too often, investors purchase lower-rated bonds, as well as bonds with longer maturity dates," Kallevig says. "The results can be devastating."

Most investors, says Kallevig, are better served by purchasing highly-rated bonds at issue and holding them to maturity.

Don't overlook the duration of individual bonds. When interest rates rise, it's paramount to understand how long you're locked in to a bond investment.

"An investor needs to be careful not to extend too far out in duration," says Daniel Milan, managing partner at Cornerstone Financial Services in Birmingham, Michigan. "The most critical mistake investors should avoid when it comes to bonds in a rising rate environment is being overweight in longer-term fixed-income bonds."

Milan says this is especially true when investors are utilizing mutual funds, since they'll be hit with a double whammy when rates rise. Generally, the longer the duration of a bond, the more risk you're exposed to as rates increase.

Understanding the duration of individual bonds within your portfolio is crucial for quantifying your level of interest rate sensitivity, says Robert Waas, founder and CEO of RSW Investments in Summit, New Jersey.

"As interest rates change, longer duration bonds should exhibit larger price fluctuations compared to those of shorter duration," Waas says. "If investors believe that rates will rise precipitously and for a prolonged time period, they may want to consider exchanging longer duration bonds for shorter securities."

McDonough says that investors need to be careful to avoid looking at their individual bond durations in a vacuum, pointing to the Fed's recent rate hike announcement.

"The Fed is raising short-term rates but longer term rates don't necessarily follow suit. Higher rates don't always cause a parallel upward shift in the Treasury yield curve, so while it's instructive to be aware of the duration of individual bonds, investors also have to look at the entire portfolio in a variety of potential interest rate outcomes," McDonough says.

Be clear about your investment targets. Another mistake bond investors can't afford is losing sight of where bonds fit within their larger investment strategy.

[See: 10 Long-Term Investing Strategies That Work.]

"Investors need to have complete clarity as to the role of bonds in their portfolio," says John Donaldson, director of fixed income at Haverford Trust, located just outside Philadelphia.

Donaldson says that role is determined by risk tolerance and cash needs, as well as the investor's individual timeline. That timeline, says Donaldson, should account for not only retirement but other major financial events, such as putting kids through college.

Matt Essmann, also a managing partner at Cornerstone Financial Services, says it's vital for investors to understand how their bond investments fulfill a specific criterion to meet their investment goals.

"That's the fundamental reasoning behind a diversified portfolio," Essmann says. "This is especially important with bonds because we're dealing with both the market value of the bond as well as the yield provided to the investor."

McDonough says it's key for investors to understand what bonds do, and do well.

"Bonds protect principal and generate income," McDonough says. "The upside is receiving your principal back at maturity, plus the coupons you're contractually owed. The potential downside is default and loss of principal, mitigated by some degree of potential recovery."

Approach future bond purchases carefully. Rising rates offer investors an opportunity to purchase bonds at lower prices but some research is necessary before committing to an investment.

"The first thing to consider is where we are in the economic cycle and from there, build tactical over- and underweights to the various sectors in the fixed-income market," McDonough says.

She also emphasizes the importance of understanding the credit and rate profile of any security that's being purchased.

"A 5 percent coupon on a long muni bond may sound attractive but the significant premium being paid can undermine some of the yield considerations," McDonough says. "Similarly, if you're quoted 7 to 8 percent on an individual corporate bond, you definitely want to check the rating. Credit spreads aren't nearly as attractive as they were a year ago, so additional levels of caution are warranted."

Essmann recommends that investors keep the bigger picture in mind when planning new bond purchases. He says there's no magic formula investors can use to shape their bond investment choices, arguing instead for a holistic analytical and tactical approach to purchasing bonds.

"Investors should be thinking about quality, yield, maturity duration, tax implications, interest rate risk, personal risk tolerance, their time horizon until retirement and how much income they think they'll need once they retire," Essmann says.

[Read: The Pros and Cons of Municipal Bonds.]

Donaldson offers a final piece of advice for bond investors.

"The single factor that most people forget is that bonds are contracts between the issuer and the investor," Donaldson says, citing municipal bonds as an example.

"Municipal bonds have very wide discrepancies between the protections offered to bondholders," Donaldson says. "Some have very strong legal protections, while others do not. Investors should think about those factors as the market rarely offers enough yield for the differences."

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