An important preliminary note:
Given what took place in both the stock and bond markets in 2022, I'm starting the new year with a short series of articles about "safe" retirement income and the roles that bonds and other instruments may play in providing it.
But from the outset, I want to reiterate some important "first principles" when it comes to our finances and stewardship in retirement:
- Our hope and treasure, which is to say our hearts, can't be in our retirement accounts, investments, or our "guaranteed income" from Social Security or other sources. Instead, it must be in God's goodness and faithfulness to us as his children.
- Meeting our reasonable spending (and charitable giving) needs in retirement is a good and wise use of the resources God has entrusted to us. Seeking to minimize risk and provide for future income is commended in Scripture and is good for us, our families, our churches, and our community.
- I may occasionally use the phrase "guaranteed income," but there really is no such thing. Nothing in this fallen world can truly be "guaranteed" except the things God has promised us. Even then, some of his promises are conditional based on our faithfulness and obedience to his Word.
- Through his common grace, God has given both Christians and non-Christians tools and resources to help manage their retirement income wisely and in alignment with biblical principles. Fixed-income securities, such as individual bonds and bond funds, are such tools when used appropriately in a diversified retirement portfolio.
Not long ago, I wrote about the sea change that is taking place in the financial markets and underlying economic dynamics, primarily due to the Fed's total reversal of decades of "quantitative easing" (QE) to aggressive "quantitative tightening" (QT).
We have entered a new era of higher interest rates, higher inflation, and lower expectations for stock market returns.
Consequently, individual bonds and bond funds have had an awful year. Paired with simultaneous stock declines, we've seen unprecedented losses (on paper, at least) of conservative and balanced portfolios containing both.
The Vanguard Total Bond Market Index Admiral Fund (VBTLX)—an intermediate-term fund—was down about 13 percent last year (including interest paid). But its yield has risen to 4.29%. This happened as the Fed has increased interest rates by 50 or 75 basis points several times, with more in sight this year.
Based on these recent events, many people wonder whether it even makes sense to hold bonds anymore. After all, as we have seen, in worst-case scenarios, stocks and bonds can both lose value—so where's the "diversification" benefit we've all been told about?
Aren't bonds supposed to go up when stocks go down, even if they don't do so in direct proportion? The answer: usually. Also, if stocks are likely to go up after sharp declines, the same can't be said for bonds. So, should I shift more of my portfolio to stocks? The answer: perhaps.
Another point of view is that bond yields are up (which is one of the reasons prices are down) and since retirees like yield (i.e., income), isn't that a compelling reason to hold bonds? The answer: it all depends.
Why is it that the answer to almost every question about long-term investing is "maybe" or "perhaps" or "it all depends"?
The short answer is, "because we can't know the future." Longer answers are more complicated.
At the start of QT, my retirement portfolio (at age 69) was about 40 percent stocks and 60 percent bonds and cash. (I'm currently sitting with about 35% stocks, 55% bonds, and 10% in cash and still following my bucket strategy.)
I hold short- and intermediate-term bond funds, including a short-term Treasury Inflation Protection Securities (TIPS) fund.
My bond funds are down an average of nine percent for 2022—something I never expected. This has caused me to ask myself these questions:
- Should I own bonds at all? If so, does a balanced portfolio still make sense?
- Should I own individual bonds or bond funds?
- Would I be better off with a "bond ladder"?
- Should I buy more TIPS?
- Should I buy individual TIPS (and build a TIPS ladder) or a TIPS fund?
- How would I build a TIPS bond ladder?
I will tackle the question in this article and the others in subsequent posts.
Alternatives to bonds
There are only a few basic investment alternatives for your retirement savings.
You can use some (or all) of it to buy an annuity. In combination with Social Security, you will receive 'guaranteed' payments from both for as long as you live. You're good to go if that's all you need to fund your retirement.
With that strategy, you won't run out of money; however, inflation could be a problem. A worst-case inflation scenario over 20 or 30 years could significantly reduce the value of the annuity payments—and you won't have anything left when you die. That may or may not be important to you.
The next major alternative is to buy bonds. You can buy them individually or in a bond fund. Most people who do the former use individual bonds to build bond "ladders." (A CD ladder offers similar benefits, but their problem—especially for long-term CDs—is loss of value due to inflation.)
That's why some experts say that bond ladders built with individual TIPS offer the safest route (since they adjust for inflation), but ladders can be built using many different types of bonds.
Comparing these two options, we can see some differences.
First, with a bond ladder, assuming you spend all the money of each "rung" in the ladder the year it matures, you'll run out of money when you reach the last rung, perhaps 20 or 30 years. But the annuity (along with Social Security) will pay as long as you're alive, which could be longer than 30 years.
In either case, you're out of money when you die. Whether that matters to you is a personal thing.
The second difference is that when you buy an annuity, you give your money (principal) to an insurance company, but with a bond ladder, you still have the money in your brokerage account invested in the bond ladder.
If you live less than 30 years, you may have something left over. Plus, you can sell some bonds at any time should you need to raise cash, but you may sell at a loss if prices are down.
Investing in a stock portfolio is the third major option that gets the most attention. (Many retirees do this and prefer dividend-paying stocks.)
With a stock-based portfolio, if you need more than the dividends they pay, you will have to sell stock shares (hopefully, appreciated ones) to generate cash flow.
With stocks, if you don't spend too much, and stocks do very well as an asset class over the 20 or 30 years of your retirement, you could end up with something to leave behind. Or, if stocks do poorly or you have significant sequence risk, you could run out of money before you die.
So, stocks have lots of upside but just as much downside. That's why we often combine them with bonds to create "balanced" portfolios.
I like dividend-paying stocks (funds) and spending those dividends as income in retirement. Depending on how much I spend, I don't have to sell stock fund shares very often. It fits well with my bucket strategy for funding my retirement.
The problem, of course, is that these stocks (funds) don't always go up and sometimes go down—a lot. You probably remember 2000 (dot com bust), 2008 (real estate crash), and 2020 (pandemic). (The S&P 500 is down almost 20% for 2022 due to rising interest rates and inflation.)
Although most retirees want (and perhaps need) to own some stocks, they should probably also hold some bonds. Many studies have shown that owning bonds can decrease a portfolio's overall risk even though overall returns will also potentially be reduced.
Of course, how much of your portfolio should be in bonds has always been debatable. A 60% stocks and 40% bonds portfolio (a.k.a. a "balanced" portfolio) has performed very well on a risk-adjusted basis since the market highs of 2000 (just before the dot com bubble crash):
As the Forbes article noted, a balanced portfolio ends up with more money than one holding stocks only, which may come as a surprise. But remember that this was a time of dramatic interest rate reductions, which drove up bond prices. It also assumes that you've stayed invested during all of the ups and downs since then.
Another good reason to own bonds (and why I have about 55 percent of my portfolio invested in them) is that they can provide a relatively safe, predictable income stream.
Individual bond and fund yields are up (a silver lining to the Fed's QT cloud). I own a U.S. investment-grade corporate bond fund currently yielding 3.4%, which is considerably higher than a year ago. Plus, yields should continue to increase as the fund's composition 'turns over,' and older lower-yielding bonds are replaced with newer, higher-yielding ones.
Good reasons to keep them
So should we buy (or hold) bonds in our portfolios? I think there are some good reasons to do so:
Reason #1 – If you invest in stocks, bonds can improve your risk/reward quotient.
Reason #2 – They can provide relatively safe, predictable income. (The "safety" factor—relative to interest rate risk—may increase using a bond ladder instead of a bond fund. There is also a very real inflation risk. More on that later in this series.)
Reason#3 – While less precise, matching bond funds' durations to known spending needs in the future seems like a better a good way to go in lieu of holding individual bonds.
Reason #4 – Buying individual bonds can be expensive. Purchasing bond funds is easy and low-cost.
Reason #5 – Bond funds (especially ETFs) are professionally managed, transparent, and easy to understand.
You may not need bonds if you decide to go the annuity route. A fixed-income annuity is a lot like a bond issued by an insurance company (they usually invest the money you give them in bonds, by the way). An annuity works like a bond with a lifetime coupon with no value when you die.
But unless you annuitize all your retirement savings (which I wouldn't recommend), you probably want to own some bonds to tamp down your stock portfolio volatility and provide income for living expenses in future years.
At age 70, I plan to keep my current bond/cash allocation of about 60%. (If you're younger, say in your early 60s, you may want a more balanced 50/50 or 60/40 stocks/bonds portfolio.)
But the next question we need to consider is whether to own individual bonds or bond funds. Given higher yields, is it time to "lock in" some of those yields with individual bonds, perhaps using a bond ladder?
I'll tackle that in the next article.