Be careful in buying bonds now because markets will become more volatile, Thornburg Investment bond managers said.

The firm’s managers, speaking to the press in New York on Tuesday, said they are sometimes accepting less than they could get in bond yields in the short term, but hope to get more later on.

Why?

The Federal Reserve’s expected balance sheet changes could dramatically affect bond yields, they said, and that could lead investors to make the wrong choice. They could be reaching for higher yield in a rising rate environment to expose themselves to unexpected risks as the bond markets head into a period of greater volatility. Investors should diversify and not bet on any one-time period for bond holdings, they said.

Thornburg officials argued that investors should be diversified in bond holding periods and use laddering instead of barbell strategies. They note that investors must be ready for almost anything owing to the uncertainty of the Federal Reserve running down its balance of $4.5 trillion. They added that, before the global financial crisis of 2007, the Fed balance sheet was less than one trillion dollars. The unpredictability, they noted, is because there is no historical precedent for the central bank running down such a huge balance sheet.

“That could create a lot of chaos,” said Christian Hoffmann, associate portfolio manager at Thornburg. The Fed, as it raises rates, will be seeking a golden mean, he added. “The balance sheet reductions are designed to create a bandwidth of acceptability. That’s political acceptability. That’s market acceptability.”

Hoffmann said he sees no dramatic changes in the near term, but investors and advisors should watch carefully as the unwinding happens. Lon Erickson, another Thornburg bond manager, warned that investors who want better yields must understand the risks and rewards as interest rates rise.

“The biggest risk may come from balance sheet rate risk. No one has ever tried this before. We don’t know what impact this will have on rates, and on the shape of the curve,” Erickson said.

He advised investors trying to protect themselves from the danger of rising rates to “understand what other risks you may be taking on.” For example, he said, some bond investors don’t seem to understand the credit risks they could be incurring.

“A good example of this is that a lot of people have gone into bank loan products,” Erickson said. “And that’s OK. That is a floating rate component. But what people have to understand is that it also has a credit risk component. It’s a high yield product. Most of those companies, if you look at their credit rating, it is below triple B.”

He added that there is nothing inherently wrong in these products, but “you have to know the risks and that you are being compensated appropriately for the risks you are taking.” Erickson said that part of the danger of bank loan products is that part of the yield is fixed, which may burn some investors who don’t understand the risk of the product if rates change quickly.

Erickson said Thornburg sometimes buys bank loan products, but they use them carefully, with an understanding of the risks and only when they are reasonable investments. The low rates of the world’s central banks have led many bond investors to seek various fixed-income products, he said. But there’s a problem.

“We don’t think the market here or globally is compensating us very well for credit risk,” Erickson said. Nevertheless, he doesn’t expect a dramatic bond sell-off in the short term.

What should investors do?

Erickson said Thornburg, which now holds a considerable cash position, is taking a careful tack in bond buying. It is buying “more defensive names” and also using investment grade floating rate products, he said. That, he conceded, comes with a trade-off in yield.

“We are willing to do that because we believe we will see an increase in volatility and we want to manage that for our shareholders,” he said, adding that this careful policy will allow the portfolio to remain flexible. Later on, Erickson said, Thornburg would have the option to trade some of these securities for higher yielding positions.