Investors are needlessly exposing themselves to huge potential losses by defying two golden rules for making money through bonds - lend more to those who will pay on time in full and less to those already saturated in debt.

Traditional fixed income benchmarks that allocate investment weight based on the volume of a country's debts have nurtured what some see as a dangerous conviction that sovereign borrowers who owe the most are the safest to lend to.

In a clarion call to investors the same week that Italy -- Europe's largest bond issuer -- passed a crucial test of its ability to borrow, Gregor MacIntosh, Lombard Odier Investment Managers' head of rates, said those who slavishly model portfolios on issuance rather than fundamentals were most at risk.

We're trying to embody a more disciplined approach to benchmark selection and the core of that is debt sustainability. We want to invest most in those countries we believe will repay not only the coupon (interest) but the principle (investment) too, MacIntosh said.

Issuance-based indexes -- often constructed by the same firms that prolific sovereign issuers hire to sell their debt -- have encouraged investors with the smallest tolerance for loss to load up on governments with the biggest public debt burdens.

Citi's Euro Government Bond Index allocates a quarter of its weight to Italy, rated BBB by Standard & Poors, but just 21 percent to Germany, 6 percent to the Netherlands and 1 percent to Finland -- three of Europe's few remaining AAA nations.

With risk-free government bonds broadly seen as a relic of the past, investors are having to rethink the way they compose portfolios or learn to live with heightened levels of volatility and risk that they have historically shied away from.

Jeff Molitor, CIO Europe at Vanguard said, the 2011 debt crisis had underlined a critical need to refocus on long-term investment truths when building portfolios, rather than on the noise of 'experts' making economic and investment forecasts.

Successful investors ... accept that the only certainty in investing is uncertainty. Daily assertions about 'risk on, risk off' can be entertaining but they are a distraction that rarely helps to build wealth over the long term, Molitor said.

Exhibiting patience and doing nothing can often be the right strategy, especially in volatile markets.

Moves by the European Central Bank to inject billions of euros of cash into liquidity-strapped financial markets have slashed the borrowing costs for stressed euro zone peripherals, prompting many investors to rapidly retune holdings more in line with their benchmarks.

Portugal, which many analysts believe will need a second European Union/International Monetary Fund bailout after Greece, proved its ability to tap short-term debt markets when it sold 1.5 billion euros of three- and six-month bills at lower yields on Wednesday, cutting the yield on its 10-year bonds from 17.4 percent to 15.8 percent.

FALSE DAWN

But some are resisting temptation to re-adjust allocations to traditional big index weights like Italy or France, instinctively sensing further trouble ahead.

You know if you go buy Italy, something is always bound to go wrong again, Jon Day, portfolio manager at Newton Asset Management, part of BNY Mellon Asset Management.

Our preferred plan of attack is to re-enter these markets through credit like corporates, where you have some kind of predictability, where spreads are still very wide and you can sleep soundly at night, he said.

Together with economic indicators that lurch wildly between optimistic and depressed on a daily basis, artificial stimuli like the ECB's Long Term Refinancing Operations have made the job of accurately pricing sovereign euro zone risk even tougher, some managers said.

This bounce in peripheral European government bond markets -- enjoy it while it lasts, Stuart Thomson, chief economist and co-manager of the Ignis Asset Management Absolute Return Government Bond fund.

Our position is to neutralize rather than go long and then wait for a chance to sell. It's dangerous to get sucked into this, he said.

MacIntosh's Lombard Odier is now running its 2.04 billion Swiss franc co-mingled sovereign portfolio against a revamped benchmark that advocates a common-sense approach to bond buys, favoring less indebted economies like Sweden, Finland and Austria over typical staples of Italy, France and Spain.

Eschewing convention paid off handsomely in 2011, with Lombard Odier's Euro Government Fund A posting a 7.7 percent return between Apr. 12 and December 31 against 4.42 percent generated by the Citi EMU All Maturities Index.

Tristan Cooper, sovereign analyst at Fidelity Worldwide Investment said investors should not pile back into troubled sovereigns until governments atoned for decades of reckless borrowing with detailed, achievable plans for growth.

Peripheral bond yields have been pushed down in recent weeks by a combination of factors...a boost from the ECB's LTRO operations and tentative progress on EU governance, he said.

However, the medium-term structural challenges in the periphery remain formidable. Hence, we think it would be rash to interpret the recent improvement as a turning point.

Time on the sidelines of the market would be well spent analyzing the make-up of benchmarks that managers use as a template for their own portfolios, and the potential bear-traps they can push you into, MacIntosh said.

People generally fear change, they like the comfort of having a comparative benchmark, of all being measured the same. The industry loves peer comparisons because it wants to make its job easy but we think our approach is more appropriate for investors needs.

(Editing by Jeremy Gaunt)

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