IS IT TIME TO BUY BONDS?By MARY LYNNE DAHL , Certified Financial Planner ™
March 07, 2021
(SitNews) Ketchikan, Alaska - Lately, I have heard several people say that they have found bonds an attractive investment to purchase for their retirement portfolios. When I asked why they found bonds attractive, the answer usually centered around the fact that “bonds (government mainly) are paying almost 2%” as the answer. Government bonds are viewed as being conservative as investments, and therefore safe, so retirees often buy them for interest income during retirement.
There are several potential problems with this scenario. First, there is what is called “interest rate risk”, then there is the “RMD rate risk” and finally, there is the biggest risk of all…. inflation. I will cover all three in this article.
While it is true that some government bonds are now paying almost 2%, and also true that this is more than government bonds have been paying up until now, the increased interest is still pretty minimal, and more importantly, it may signal a potential danger facing retirement investors. My concern is not just that 2% is hardly worth taking any risk at all. It also is that many investors will overlook another risk, which is loss of principal if/when they sell their bonds prior to maturity. Let me explain.
Interest rate risk: New bonds are initially sold at “par”, which is $1,000, but if they are re-sold, by the first investor to a second investor, they sell in what is called the “secondary market”, at various prices other than “par”. If interest rates are rising above 2%, a buyer will look for a bond paying more than the 2%. The 2% bond is no longer worth as much as a new, 4% bond.
For example, a 10-year bond paying 2% which is sold one year after being purchased at par ($1,000) by the first buyer, will sell for 8.1% less than par ($918.89) when the interest rate on 10-year bonds rises to 4% instead of 2%. The 4% bond is worth more than the 2% bond because it pays higher interest. If interest rates rise to 5% on new bonds, that same bond will sell for 15.4% less ($845.57). These numbers represent real, actual losses of principal to the investor who bought their bond at “par”. A bond with a term longer than 10 years until maturity will suffer greater loss if it sells prior to maturity during an economic cycle of rising interest rates. Today, we see interest rates starting to rise, with investors thinking that now is a good time to get more interest. However, they could suffer a loss of principal if they need to sell their bond prior to maturity, and even if not, they will be getting a lower interest rate than new bonds. This risk is called “interest rate risk”. Bond prices are inverse to interest rate on each bond, which means that if a bond pays 5% when purchased and interest then increase, the price on that bond will decline. In the reverse situation, if a bond is issued with a 5% interest rate and subsequent interest rates fall, the price on that bond will increase. This is a rule of thumb, not something that is negotiated.
Inflation risk: The first problem for these retired investors is inflation itself. Inflation erodes the purchasing power of a dollar. The US Federal Reserve has targeted a goal that inflation should be at around 2%, to provide enough stimulus (spending) to keep the US economy growing. If it does not, the risk to the economy is recession, or even depression in a more severe cycle. The view of the Fed is that a little bit of inflation is good, but the Fed also watches out for too much inflation.
For some investors, the solution is not to buy government bonds paying only 2%. Instead, they buy stocks paying dividends of 3%, sometimes more. This is not unreasonable, but stocks do have their own risks, so selecting high quality stocks that pay dividends, especially rising dividends, is important. Based on the continued low interest rates, there has been a paradigm shift that has moved many investors out of bonds and into high dividend stocks. Stocks can drop in value, but we know that as interest rates rise, bonds drop in value also. Stocks, however, have historically risen in value more often and by greater percentages than stocks, so many investors prefer them, especially if they intend to also withdraw from the growth that their stocks have gained over time. There is just not much growth potential in bonds, particularly when interest rates are on the rise, but stocks may still rise, as we have seen repeatedly. Be prepared for some volatility, however, and learn to weather the storm with stocks. Historically, stocks have outperformed bonds by a large margin over long periods of time, so if you have a long view, stocks generally have more potential for gains than bonds.
For other investors, the solution is not to buy stocks at all, but to buy “junk bonds” instead. These are bonds that pay higher rates of interest, but for a reason. The reason is that they are much riskier than the bonds that pay a lower interest rate. The stand a much higher chance of failing by default, or they have a provision that allows them to be “called” (cancelled) prior to maturity, thereby eliminating the costs of paying the high interest to the investors.
And, as always, there are investors who are so desperate for higher interest income that they fall for all kinds of scams. Like your grandmother told you years ago, if it looks too good to be true, it most likely is not true. A promise of a really high return, low risk and guarantees, is generally a big, fat red flag that you are about to be taken by a scam. Do not believe it and do not waste your hard-earned money if it sounds too good to be true. The risks and the dangers are real. You can avoid risks associated with junk bonds and scams, but you cannot avoid the risk of inflation. It is almost always a factor in an economy with any degree of growth.
At a moderate rate of inflation of 2%, in 10 years $1,000 will only be worth $820.35 in purchasing power. If inflation is 5% for 10 years, $1,000 will only be worth $613.91. During the 1970s, inflation rose to 21% and people could not keep up with prices even though it was not hard to get 15% -18% interest income from bonds and certificates of deposit. Even at low rates of inflation, the result over 5, 10 and 15 year periods of time is that you lose purchasing power, with the result being that it is hard to keep up with inflationary prices. You have to get a better return on your investments than the rate of inflation in order to stay afloat, especially after retirement. Locking up your money in bonds that pay less than inflation, during a rising interest rate cycle, is dangerous.
The impact of rising interest rates is a risk to all investors, but especially to retirees and those close to retirement. A bond portfolio that cannot keep up with increasing prices dooms the investor to ever decreasing purchasing power. Don’t downplay this real risk. If you intend to live on bond interest, fully or partially, be prepared to cut your budget in a few years, or eliminate all debts if you have not done so already. As the years go by, your dollars will buy less and less, thanks to inflation.
RMD risk: To make matters worse for retirees who are depending on bond interest for retirement income, the IRS requires a minimum withdrawal every year (RMD) that must be distributed from retirement plans starting at age 72. The withdrawal rate starts at approximately 4% per year in year 1 and goes up slightly every year. The problem with this is that if a retiree is only getting 2% interest from his or her bonds, but is required to withdraw (distribute) 4% or more from the bond portfolio, he or she will have to take 2% from principal as well as the 2% interest the bonds are paying.
For example, if you have $100,000 in an IRA that earned bond interest of $2,000 and you take a 4% RMD, you will have to take out the $2,000 of interest PLUS another $2,000 from the principal, leaving you only $98,000 to earn interest at 2%. You will thereby deplete your principal and have less and less interest income with a bond portfolio that pays only 2% per year on a declining principal amount. This violates one of the most basic investment rules, that of leaving principal to grow so that it will protect you from the losses due to inflation.
The bottom line is that in retirement, a portfolio that is an important source of retirement income should produce a rate of return that equals inflation + withdrawal rate + a growth rate. If inflation is 2% like the US Federal Reserve wants it to be, your investments should average a total return of 2% + 4% + 2% in this example, or 8%. This is pretty hard to achieve if your retirement funds only earn 2% per year on average. As prices rise, it will become harder and harder to afford the lifestyle you have saved up for so carefully. This risk is what faces investors today, in a low interest rate economy that is showing signs of rising interest rates.
If you are retired, or facing retirement in the next few years, it is time to face the issue of whether or not, and how much to use bonds for retirement income. Thinking long term, with inflation as a real risk, plus the RMD withdrawals that you are required, starting at age 72, to take from a retirement plan, is the place to start. Get out your pencil and crunch the numbers, or get professional advice on how to figure this out. The best advice will be provided by a professional who is a fiduciary, who is required by law to put the interests of the client before his or her own interests. The solution is to have the data you need and a plan that offers a roadmap to your goal. A financial roadmap will get you to your destination with the least risk and the best potential for long term success.
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