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The Bond Bears Are Out of Hibernation. What Are Your Alternatives?

The Bond Bears Are Out of Hibernation. What Are Your Alternatives?
Matthiashaas | Dreamstime.com

By    |   Thursday, 03 May 2018 04:00 PM

Imagine the perfect summer day: You’re out on the open water, sipping a drink, and relaxing on a sailboat. The wind is at your back and is catching the sails just right. This has been the bond market retirees have experienced for the past few decades.

Now, flip the switch, and sail into the wind. You cannot sail directly into the wind; it’s much more challenging and you have to zig and zag to get from Point A to Point B.

This is the bond market today and the forecast for the time being. The winds have shifted from the ideal smooth sailing environment, to a headwind and rough waters environment.

Just because it was smooth sailing in bonds for as long as most pre-retirees and retirees can remember, does not mean smooth waters are ahead.

Over the past 30-plus years, retirees with a traditional 60% equity / 40% bond portfolio have been blessed with a bond portfolio with the wind at their back. In June of 1981, the Federal Funds Rate peaked at over 20% and bottomed at near 0% levels after the 2008 recession.

With the economy strengthening, interest rates have started to rise and we can expect three more forecasted interest rate increases throughout the rest of the year. We all know, as interest rates rise, bond values drop. It is a mathematical fact; you will not get the same return out of bonds as retirees over the past three decades enjoyed, as you’re essentially sailing into the wind for the foreseeable future. That’s why when we look at bonds, we look at them in terms of yield, and right now the yields are very low.

We haven’t seen a rising interest rate environment, coupled with low inflation, since 1950, let’s take a look at some stats from 1950 to 1959:

Real returns remove the effects of inflation
Source: Ibbotson Data

What does this tell us? It tells us that bonds can be risky. It also tells us that longer term bonds can drop significantly in a rising interest rate environment. The main take away for today’s retirees and pre-retirees, is that we may need to rethink the approach to the traditional retirement portfolio.

Fortunately, Roger Ibbotson, one of the most respected names in finance, decided to delve into this issue for himself. Roger published the first edition of Stocks, Bonds, Bills, and Inflation, is currently Chairman and CIO at Zebra Capital Management, and also served as a Finance Professor at the Yale School of Management for 30 years. He recently published an in depth whitepaper entitled “Fixed Indexed Annuities: Consider the Alternative.” He takes a dive into exploring annuities as an alternative to bonds, and concludes they are a great alternative for those approaching retirement in today’s economic environment. He states the following in his conclusion:

“Fixed Indexed Annuities have many attractive features as both an accumulation investment and as a potential source of income in retirement. In simulation, the FIA performed better net of assumed fees than long term government bonds. We showed the FIA had comparable volatility to bonds but with better downside protection. In our study, when bonds underperformed, the FIA performed quite well. It is our view, considering today’s low interest rate environment and our modest expectations for bond returns in the coming future, FIAs are an alternative to consider.”

Annuities are not the only alternative to consider. A higher net worth investor may look to build a staggered bond portfolio or invest in shorter term bond funds. But for the average investor, this isn’t the best option, as the yields on investment grade bonds will not generate the income their looking to retire on. For a more aggressive investor, who is willing to take on more risk, they can shift into more quality dividend paying stocks to provide income. The drawback to this method is you will see additional volatility in your portfolio, which most retirees are not willing to accept. There are other fixed income vehicles that you can turn to, such as Floating Rate Notes (FRNs), or Treasury Inflation Protected Securities (TIPS). FRNs are almost immune to increasing rates, while TIPS increase with inflation, but again, these investments are not generating high enough yields to produce the income most retirees are looking for.

The worst alternative, however, is one of the most common we see - moving to cash. The Fed says inflation has been around 2% in recent years (I would argue it’s been higher). At a minimum, your purchasing power is being devalued by inflation, and you’re missing out on valuable compounding periods. The bottom line, with the markets nearing all-time highs, and interest rates rising from all-time lows, this is a perfect storm for retirees. Finding a trusted advisor is more important than ever.

Steven Paul is an Investment Advisory Representative at Richard Paul & Associates.Steve holds his life and health insurance licenses in Michigan and Florida. He is a Certified Financial Planner™ (CFP®) and completed the CFP Board required curriculum through Eastern Michigan University and Kaplan. He received his bachelor’s degree from Wayne State University, majoring in economics.

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Just because it was smooth sailing in bonds for as long as most pre-retirees and retirees can remember, does not mean smooth waters are ahead.
bond, bears, hibernation. investors
Thursday, 03 May 2018 04:00 PM
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