How to Manage Behavioral Biases in the Bond Markets

Mar 05, 2019

 

How to Manage Behavioral Biases in the Bond Markets

 

Equity investors aren’t the only ones who find it hard to resist the thundering herd heading for the exits when markets are volatile. Investors in fixed income products such as corporate and junk bonds may succumb to the same behavioral biases. We spoke to Irena Alagic, fixed income specialist with J.P. Morgan Private Bank, about how these behaviors manifest themselves in today’s bond markets, and the steps investors can take to help protect the wealth of their future selves. Here are some of the highlights:

Remember what you Hired Fixed Income to Do

One reason why investors may look to hold a mix of stocks and bonds is because bonds offer interest income from their coupon payments.

Some argue that fixed income has lost some of its diversification benefits—one reason may be that interest rates are low. But Alagic disagrees. A recent example of this potential for diversification was the performance of leading bond and equity indices in December 2018. The S&P 500 equities index’s monthly return in December was minus 9.18%1, while the Bloomberg Barclays US Aggregated Broad Fixed Income Index’s monthly return in the same period was 1.84%.2

“It’s important to own the appropriate amount of core (high quality, longer-dated) bonds as we get later in the economic cycle, so you can get that benefit if we have more volatility,” she says.

Think Before you Act

Like equities, some investors have a tendency to buy or sell bonds when market volatility is high rather than taking action based on their investment goals... This behavior is so prevalent that behaviorists like Private Bank’s Michael Liersch call it ‘recency bias’. Basically, people are inclined to take what’s happened recently and apply it to the future.

“It should all come back to the reason you bought that asset for your portfolio in the first place, and whether it’s still serving that purpose,” says Alagic.

Don’t Forget the Coupons

One feature of investing investors should take into account is the interest or ‘coupon’ payments they forgo if they sell their fixed income bonds.

“If circumstances have changed for the issuer, then it’s absolutely worth reevaluating whether you should buy or sell their bonds,” says Alagic. “But if you believe the issuer will pay you back and the price dislocation is temporary, then the coupon is ultimately what’s going to help cushion your total return experience.”

Re-evaluate your Riskiest Corporate Bond Holdings

Investors should scrutinize their lowest–rated bond holdings, and determine whether they are comfortable with the creditor protections they provide.

“At some point we are going to have a downturn in credit markets, which have a cycle that closely relates to the economic cycle. During a credit down turn, credit markets usually sell off, default activity picks up and the riskiest borrowers usually see reduced or eliminated access to capital markets,” says Alagic. “At that point, it’s really going to pay to know what you own. You can’t only rely on credit ratings. You really should take a very close look at parts of the market where underwriting standards have deteriorated.”

Reframe your Financial Decision Making

The key takeaway is to revisit what your investment goals are with your financial advisor, to determine if you should take action, or ride out the volatility. In our view, it would be prudent to focus on yourself and not the markets—research suggests that analyzing moment-to-moment market movements can actually diminish returns over the longer-term.

LEARN MORE FROM IRENA ALAGIC

 

Footnotes

1. S&P Dow Jones Indices: S&P 500 Index, monthly return for December 2018. It is not possible to invest directly in an index. https://ycharts.com/indicators/sp_500_monthly_return. The S&P 500 is widely regarded as the best single gauge of large-cap U.S. equities. There is over $7.8 trillion benchmarked to the index, with index assets comprising approximately $2.2 trillion of this total. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.

2. Bloomberg Barclays US Aggregate Bond Index monthly return, for December 2018. It is not possible to invest directly in an index. http://performance.morningstar.com/Perforance/index-c/performance-return.action?t=XIUSA000MC
The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, Mortgage-Backed Securities (MBS), Asset-Backed-Securities (ABS) and Commercial Mortgage-Backed Securities (CMBS). https://www.bbhub.io/indices/sites/2/2016/08/2017-02-08-Factsheet-US-Aggregate.pdf

 

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