We live in trying times, as you painfully know, should your retirement money be in bank CDs or other fixed-rate places. Interest rates are at historical lows and so are your interest earnings. This is driving many yield-starved savers to take more risks with the money they’ve earmarked for retirement. It is important that you make absolutely sure your retirement money is working as hard as possible but is also rock-solid safe. In today’s low interest rate environment many risk avoiding retirement-minded Americans are investing in bonds for the first time in their life. The watchwords are: “Caution: Bond Could be a Four Letter Word”. This is not to say that bonds should not have a place in your retirement plans, but it is important you understand bond basics so you can make suitable decisions with your hard-earned retirement money.
If you’ve read my other blog entries you’ve run across one of my favorite expressions: “Risk and Reward are Traveling Companions”. This simply means that if you are promised above-market earnings potential, you’ll also be adding more risk. For example, if you put your money in the stock of a publicly traded company, you have the potential to earn a very high rate of return – you could double, triple or more if the company does exceptionally well. On the other hand, if the company does exceptionally poor you could lose most, if not all your money. With big upside – lots of earnings potential – also comes big downside – lots of potential for losses. Please keep the “risk and reward” trade-off clearly in your mind as you continue reading.
Most of the people I know in retirement are concerned about damages to their hard-earned nest egg that they’ve planned to carry them through retirement. They realize that retirement is a long journey, the road is winding and the hazards are many – they also know that you can’t borrow the money to pay for retirement. If your working years are behind you, that generally means paychecks are also in the past. Yes, you’ll have Social Security and maybe a pension, but mostly you’ll be drawing down the money you’ve been able to save over your working years. So, taking care of that money is front-and-center in most retirees’ minds – there are enough risks in life without going out of your way to take more. Running out of money before retirement ends is on the mind of every retiree and some are laying awake at night worrying about it. Once retired, you simply can’t afford to lose your retirement money because you have no way to replace it.
The running-out-of-money fear is prompting some retirees to take more risk and that is my topic here. Before bonds are discussed, I encourage you to find a financial advisor and work with him or her to plan the right retirement solution for you and your loved ones. Remember, one size does not fit all and one of the biggest risks you may face in retirement is managing your money without professional help – this is tantamount to being your own doctor, lawyer, accountant, spiritual advisor or pharmacist. I know most people don’t view it that way, but investing your money in suitable places for your circumstances is best done with professional help.
Low interest rates are driving people to consider places they’ve usually avoided because bank CDs, fixed annuities and other safe places are just not paying enough. In recent months there has been a stampede towards high yield bonds and bond funds – bond funds are sometimes called income mutual funds or balanced mutual funds. Also, to get the interest earnings you can no longer get from your bank or a fixed annuity, you must commit your money for longer periods of time or settle for lower quality – either way you are likely taking more risk. Higher rates may be found in longer term and high yield “junk” bonds, along with more risk than the safe-money places. The question is: can you afford the risk? Many of the bond issuers are blue-chip companies, municipalities and other governments, so what could possibly go wrong? Where is the risk? Let’s discuss the basics of bonds.
First of all, all bonds are rated by independent rating agencies like Moody’s, Standard and Poor’s, Fitch and others. Since the rating agencies missed the mortgage melt down and house collapse, we know they are not infallible – in fact, they are sometimes just plain wrong and if so, it could be you that suffers. If your bonds are down-graded to a lower rating, their value will likely drop because buyers will view them as more risky. This is probably the lesser of the risks, but you should know that not all bond issuers are the same and that assigned rating can change over the economic cycle.
The United States Treasury, or the U.S. Government, has the highest rating and you can be assured that your principal is safe. However, your principal will not be repaid until the bond matures and that could be as long as 30 years in the future. So the longer the maturity you choose, the more risk you assume because there is simply more time for something to go wrong – either in your circumstances or the markets. That’s why longer-term bonds offer higher interest rates: more risk. Remember the traveling companions, risk & reward?
If your bonds are issued by a corporation or smaller government entities such as cities, counties and special improvement districts, more things can go wrong than with U.S. Government bonds. History is replete with local governments being unable to repay their bonds at maturity. In recent times many bond ratings of cities and other local governments have been lowered in response to the Great Recession, falling tax receipts, high unemployment and over-spending. The longer you must wait until your principal is repaid, the higher the risk of something going wrong. As you will learn below, the safest of bonds have risk because price and market value are affected by interest rate changes.
Let’s say you purchased a bond a few years back and it has a fixed rate of 8%. This fixed-rate, called the coupon, determines how much in interest earnings you’ll receive from the bond issuer. Your 8% bond is worth more if rates on similar bonds fall to say 3% but would be worth less if the rates on similar bonds rose to 15%. Do bond rates fluctuate this much? Today’s bond rates are very low with 2% to 4% being normal for high quality bonds whereas in the early 1980’s similar bonds offered rates as high as 20%. So, yes, bond rates do change drastically with the economy.
Bond prices and interest rates have an inverse relationship: if interest rates fall, bond prices rise and vice versa. Why? Because if your bond’s coupon is 8% and if a comparable new bond has a coupon of 4%, investors will pay you more because your “cash flow” or “interest earnings” are higher. In other words, they would have to invest more in a lower coupon bond to get the same earnings as you get from your 8% coupon bond…so they would pay a premium to buy yours. Contra wise, if the 8% rate on your old bond is less than that of a comparable new bond, investors would pay less because of the lower cash flow. Of course, at maturity you’ll probably get your principal back but that day could be years, if not decades, in the future. As you’ve all heard, there is a time value of money because a dollar today is worth more than a dollar in the future. If you had your dollar today, you could put it to work earning interest – you can’t do that with the dollars you’ll receive later when your bond matures. Thus, when interest rates rise your future dollars at maturity become less valuable and investors will pay you less for them. The longer it is until maturity, the more your bond price will change for a given fluctuation in interest rates because the lower cash flow will last longer and the principal repayment in the future is worth less.
So if you are keeping your retirement money in bonds, you are also betting on which way interest rates are going in the future. Given that current interest rates are at historical lows, does it make sense to “bet” that rates are going even lower? Doesn’t it seem prudent that in low-rate times you should keep your investments in short term maturities, but when rates are high you should lock in the high rates for a long time? Two problems with this observation: (1) many times when we think rates are low, or high, and can’t change much, they change substantially — we simply can’t forecast future interest rates, this creates risk; (2) keeping your money in short term bonds when rates are low means you’re also getting the lowest bond rates and this may be unacceptable if you need more interest income.
Why are retirement-minded people putting their retirement money into long-term and extra high yield “junk” bonds? They are simply trying to increase their earnings or income and have not given careful consideration to the risks. I’m sure some people think that if rates rise they can “not sell” their bonds and thereby avoid losses. Is this solid logic? If old bonds are yielding 4% and comparable new bonds yield 8%, holding the old bonds involves an opportunity loss. You’re locked into a rate that is lower than market and therefore are not earning what you could if you were not locked into the lower rate bonds. The loss is simply spread out over many years, but is nonetheless still there and very real. In other words, you can bleed all at once by selling or you can slowly bleed for years by not selling. But there is another complication that needs to be considered: inflation.
Generally interest rates and inflation move up and down together – not in exact lock step but on the same wavelength. If you look at the early 1980’s, our last period of really high inflation, you’ll see that inflation topped out at an annual rate of about 15% in early 1980 and interest rates reached their peak later in the year. So, if you’re holding low rate bonds and there is rampant inflation which pushes interest rates higher, you’re losing twice: you’re getting relatively less interest earnings from your investment and the interest you’re earning, plus the principal you’ll get back at maturity will buy less.
As I’ve shown you, even the safest of all longer-term bonds – U.S. Treasury bonds – have risk because of changing interest rates and inflation. You now know the pitfalls associated with bonds. Still bonds can have a place in your retirement plans – it all depends on your circumstances, tolerance for risk, tax situation and other considerations that are best identified by working with a professional financial advisor. If you found the foregoing confusing, all the more reason why you need professional assistance.
How can you avoid the mistake that many of your fellow retirees are making? You can learn a lot more about bonds – you’ve gotten the basics from this writing – and you can then work with your financial advisor to make sure that where you keep your retirement money is a suitable place for your circumstances. Remember, you don’t practice medicine, law, accountancy or religion without professional help, so please don’t practice financial planning without it either.
Shelby J. Smith, Ph.D.