22 July 2018

Why You Still Need Bonds in Retirement

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By most objective measures, now is a terrible time to own bonds. Short-term interest rates are near 0%, and even 30-year Treasuries pay around 3% interest. Because of the way bonds react to interest rate changes, a 30-year Treasury bond could fall around 20% in market price from a one-percentage-point increase in interest rates. With interest rates expected to rise in the not-too-distant future, it might even seem crazy to be anywhere near bonds at the moment. Despite those risks, if you're retired or expect to retire in the near future, you really should own bonds as part of your retirement portfolio. Because of low current interest rates and likelihood of higher rates to come, however, not just any bond will do. Instead, you should focus the bond part of your portfolio on the very specific benefits that bonds can bring you that stocks cannot.

What bonds do better than stocks
Bonds have two key characteristics that earn them a space in a retiree's portfolio, even in today's low-interest-rate environment. First, they have a higher certainty of payment than stocks do. Companies can and do cut their dividends if they feel sufficient financial pinch, with no risk other than to their stock prices and reputations. The second key characteristic that bonds have that earn them a space in a retiree's portfolio is that they mature. On that maturity date, the issuer must pay exactly the face value of that bond to whoever holds the bond -- or else face that same risk of default. Companies typically either pay off their bonds with cash they've accumulated from their operations or they roll over their bonds by issuing new ones and using the proceeds to pay off the maturing ones.

Ladder up to use bonds successfully today
That combination of a high likelihood of payment and a known expected value on a known date provides the one-two punch that earns bonds a place in your retirement portfolio. Still, in today's low-interest-rate environment where rates are expected to rise, not just any bonds will do. The way to use bonds successfully in today's environment is to take advantage of that known payment and maturity schedule to create something known as a bond ladder.

A bond ladder is a collection of bonds with maturity dates that move progressively further out. When you set one up for your retirement, the goal is to be able to use the cash generated by the maturing bonds to help cover your costs of living. Since you're looking for these bonds to provide your retirement cash flow, you'll want to stick with either Treasury bonds or diversify among high-quality, investment-grade corporate bonds.

When setting up your bond ladder, include a reasonable estimate for inflation for the future years, so that you have a decent chance of preserving your purchasing power from those maturing bonds. You'll initially want your bond ladder to last somewhere between seven and 10 years, though that number may flex both up and down a bit as you work your way through retirement. The rest of your retirement portfolio can remain invested in stocks, for their greater long-term growth potential.

The seven-year minimum is important because you don't want to have to rely on selling stocks to cover your basic living expenses. Money you need to spend within the next five or so years does not belong in stocks. By starting with at least a seven-year ladder, you have two additional years of cushion to draw down your ladder without getting below that five-year limit if the stock market doesn't cooperate in the short term.

How to maintain your bond ladder throughout retirement
Once you've set up your bond ladder, you spend the cash from your maturing bonds to cover your costs of living. As time passes, your existing bonds all get closer to their maturity date, and your bond ladder shrinks in length as a result. To help assure your bond ladder lasts as long as your retirement, though, you'll need to keep replenishing it by buying bonds that mature farther out in time.

You'll have three sources of cash to buy those bonds. First, the existing bonds you own will probably be paying interest, which can be reinvested in other, longer-term bonds. Second, your stocks may pay dividends, which can also provide you with a source of cash to reinvest in those bonds. Third, you'll have the stock portion of your portfolio, from which you can sell off a bit to extend that bond ladder.

In a normal year in the stock market, you can use some of your stock gains to replenish the longer-term end of your bond ladder. In a really good year in the stock market, you can even extend the length of that ladder further. When the market doesn't cooperate, you won't be forced to immediately sell to cover your costs of living. You'll just let the bond ladder shrink a bit and wait for a market recovery.

Bonds can still help retirees -- even today
In a time of low interest rates that are expected to rise, bonds can be an incredibly scary investment. Still, by creating a bond ladder and looking for the maturing bonds to provide cash flow to cover your costs of living, you can put them to productive use in your retirement, even today. Just be sure to invest in bonds with that goal in mind, and you'll improve your chances of successfully using them as a key part of your retirement funding plan.

Click here to access the full article on USA Today.

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