Stocks, bonds and cash. These are the three main asset classes that make up a portfolio and the percentage allocated to each will change over time as one ages. A younger investor will be primarily exposed to equities and will not mind the volatility as much as an older investor because time in the market is on the younger investor’s side. As one ages the percent of a portfolio that is in stocks will decrease, while cash and bonds will increase. Bonds have historically been the safe haven for an investor who is nearing or in retirement. They generally cushion the blow of the volatility in the equities markets as the movements of the two have been basically negatively correlated. The following chart shows the negative correlation from roughly 2015 to present, with the exception of the pandemic period.
One must remember that all bonds are not created equal, with some garnering more risk than others. The gambit runs from what are considered risk-free bonds, which are those that are backed by the full faith of the US government, to municipal bonds and on to corporate bonds. This is where a retiree must be careful. In this low yielding environment, many will find themselves chasing higher rates in the form of junk bonds, or corporate bonds that are rated at below investment grade. According to Allan Roth, a certified financial planner and accountant at Wealth Logic, based in Colorado Springs, Colo., “Bonds are the single biggest mistake I see over and over and over again. Bonds should be boring … and allow you to sleep at night.”
There are a couple of ways to safely invest in bonds as you approach retirement, albeit not fool proof. In fact, last year was a rare year in which government bonds actually lost money, however in general they will hold their ground when stocks fall. Most people have a modicum of knowledge regarding stocks, but bonds tend to get viewed as complicated with interest rates, yields to maturity, call features, etc. The average person probably doesn’t want to deal with this, which is why mutual funds or exchange traded funds emerged. Using a fund is by far the simplest way to do it. Two of the bellwether behemoths of the bond industry are the Vanguard Total Bond Market Index Fund (VBTLX or BND) and iShares Core U.S. Aggregate Bond ETF (AGG). There are a myriad of others as well as low cost balanced funds, which diversify across both stocks and bonds. Ask your financial advisor to review these options with you.
A slightly more involved strategy, but one that also can help fight rising interest rates as in our current economic environment, is establishing a bond ladder. As mentioned, bond returns actually declined in 2021 and may be on a course to repeat those losses this year as the Federal Reserve raises interest rates in an attempt to combat inflation. Remember that bond prices move in the opposite direction of rates themselves, since the yields on new bonds look more attractive by comparison. This opinion is widely reflected currently by Wall Street analysts. According to Michael McClary, chief investment officer at Valmark Financial Group in Akron, Ohio, “We are in a very precarious position with bonds right now.”
So what exactly is a bond ladder? In financial jargon, a bond ladder is a strategy that attempts to minimize the risks associated with fixed-income securities while managing cash flows for the individual investor. For the rest of us, the basic strategy entails holding individual bonds like U.S. Treasury’s to the end of their term. Holding an individual bond to maturity guarantees the investor will get back their principal plus the stated interest rate. It locks in their price. The following chart can give you a better look at how a ladder can be established.
If an individual invested $100,000 in a 10 year US Treasury bond that paid a 2% interest rate, the investor would receive $2,000 in interest payments each year, and get their entire $100,000 principal investment back at maturity. However, someone who locks their money away in one 10-year bond may miss out on higher-yielding ones issued during that decade. A bond ladder fixes this problem. By using the bond ladder approach, you could buy five different bonds each with a face value of $20,000 or even 10 different bonds each with a face value of $10,000. Each bond would have a different maturity. Each different bond maturity represents a different rung on the ladder. While the bond ladder approach typically applies to treasury bonds, it can be used with any type of fixed income product, even certificates of deposit (CD’s).
Perhaps the biggest issue an investor would face with investing in bonds is the difficulty of understanding how bonds work and how one receives value. Establishing a bond ladder makes sense if you can follow all the moving parts. If you keep it strictly vanilla and invest in a ladder of government bonds it’s easier to follow and manage. However, if you or your advisor wants to chase yield and invest in other fixed income securities like corporate bonds, the risks and the actual investment become more difficult to follow. That’s where one can turn to the ETF bond funds. You could actually ladder bonds by using ETF’s that have different maturities. While not as exact as the actual bonds themselves, the ETF provides a simpler way to gain exposure to different maturities. Either approach can help you with your bond investing in what looks to be a rising rate environment.