With interest rates still hovering near their historic lows, retirees relying upon yield for their income have reached a precarious tipping point. The danger is even greater for retirees who have been searching for higher yielding vehicles in order to boost their income. We may have reached the point where the risks of reaching for yield in retirement far outweigh the possible returns. Going forward, it is becoming more important for retirees to fully understand the risks of reaching for higher yields, and to realize that there’s more to retirement income than just yield. In today’s environment, retirees need to consider different strategies for turning investment returns into sustainable income.
When Interest Rates Rise
Most investors understand the inverse relationship of bond prices and interest rates. When interest rates increase, bond prices can fall. The search for yield has led investors down the road to find bonds with longer term maturities because they have higher yields. The problem is for every 1% increase in rates, the price of a bond will decline around 1% for every year of duration. A bond with a 20-year duration could decline as much as 20%, where as a bond with five years of duration might only decline 5%.
If you were lucky enough to purchase long-term government or investment-grade corporate bonds back when they were yielding 5 or 6%, you could simply hang on to those until they mature, and you will receive back the full value of the bond. But then you would have to reinvest it at current interest rates which are well below 3%.
When You Lower Your Standards
Investors know, that to reduce risk and volatility they should hold high quality investment grade bonds rated “A” or better. The problem is the more highly rated bonds don’t yield nearly as much as noninvestment-grade bonds rated BBB or lower. Because of their higher yields, low-rated bonds are more interest rate sensitive which could result in greater price volatility. The larger risk, however, is that low-grade bonds are rated as such because they present a greater risk of default.
When You Invest in Something You Know Little About
When yields sink to near zero, a lot of investment alternatives seem to spring out of the woodwork. We saw the damage caused by financially engineered products such as collateralized debt obligations and mortgage backed securities. Not only are these products still on the market, but others are springing up, such as leveraged loans and direct lending partnerships. Yield seekers may also be lured into more complex investment vehicles that can certainly produce yield but it would take an M.B.A. to figure out just how they do it. Oil and gas master limited partnerships (MLPs) and some Real Estate Investment Trusts (REITs) can generate very enticing yields, but it would be important to know exactly how you get paid.
Understanding the Risk/Reward Relationship
Everything about this discussion comes down to the risk-reward relationship. It is extremely difficult, if not impossible, to increase your return without simultaneously increasing your risk. The amount of extra yield you might be able to generate by going longer-term or lower-grade simply can’t provide the cushion you’ll need when the market turns against you.
Focus on Total Returns
Retirees need income, but they also must be able to preserve their capital. By focusing on yield, or income alone, you can increase the overall risk to your portfolio. It’s time to think beyond yield and consider a broader source of income through total returns. Total returns are generated by a broadly diversified portfolio of stocks and bonds allocated among a number of different asset classes. The objective of a total return retirement income strategy is to generate a current income that can satisfy a desired draw down percentage while growing capital at a rate that can keep up with inflationary pressures. Even a conservative portfolio invested in a balanced mix of equities and different types of debt instruments has historically generated a total return sufficient to draw down an income while preserving your capital assets.
At Net Worth Advisory Group, we have always believed in the in the concept of total return and the important role that it plays in helping provide our clients adequate retirement income. Bonds will continue to be a vital component of our diversified portfolios despite uncertain interest rate conditions. As always, we will meet with our clients regularly and determine the optimal level of bonds for their individual portfolio needs. Certainly, our current bond portfolios have limited exposure to the long bond and also focus primarily on holding high quality investment grade bonds. It is important to remember that there are many factors in addition to interest rates that influence the price of bonds and we want to avoid thinking that we can time all of these events. We believe a more sustainable approach to successful investing includes a well thought out long-term strategy devoid of emotional responses to market pundit’s prognostications.
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