Bonds are typically seen as the “safe” investment for those nearing or in retirement. Typical portfolios shift to containing 40% or more in bonds, with the 60/40 portfolio being a particular favorite. But why? Are they really safe? And what happens when Bonds Bomb?
In this episode, we look at the two main elements of using bonds: Income and Stability. Bonds bomb at both.
Bonds as Income
Bonds are often used as income-generating investments. They pay interest, and that interest is often distributed to retirees as income.
Those who buy bonds directly get the stated interest payments for the stated duration. If you buy a long-term 30-year bond at 6% for $1,000, you’ll get $60 paid out each year for thirty years and then get your $1,000 back. Put $1,000,000 into bonds paying 6%, and you’ll get $60,000 per year for thirty years. This 6% is called the yield. It “yields” 6%. That’s better than the “4% safe withdrawal rate” of equities ($40,000) or even a more aggressive 5% withdrawal rate ($50,000). That seems like a good income.
Here’s the problem: It’s a flat income amid rising costs.
If the cost of everything you want and need to buy will double or triple over your retirement (it will), then a flat income will be cut in half or to a third over that same period. Your $60,000 per year will feel like $30,000 or even $20,000 per year by the end. If you needed $60,000 to live at the beginning, how are you going to live on $20,000 at the end?
But you’ll get your principal back, right? The bond matures at the end of 30 years, and you receive your $1,000 back (or $1,000,000 in this example). That’s true, which makes it better than an annuity. Annuities may pay a similar income, but you get squat returned at the end.
I refer back to the doubling or tripling of cost due to inflation, which will turn that $1,000,000 into $300,000-$500,000.
You cannot live on even 80% of your required income, let alone a half or a third. As inflation starts to dig into that $60,000, you’ll need to start selling off some of your bonds to make up the difference. But as you do that, you’ll have less and less of them to generate interest income. This means you need to sell more and more of them to get your income.
Evaluating bonds by their yield is a poor way of creating income. You must look at their “total return,” their interest payments, plus what you can sell them for.
The long-term total return of bonds is 6%.
If inflation averages 3%, that means the real long-term total return is 3%. If you are withdrawing any more than 3%, you are decreasing your portfolio and racing against time. Which will run out first? Your money, or your time on this earth.
Most people need to withdraw more than 3% of their portfolio for income. Thus, bonds bomb.
The long-term total return of equities is 10%. The real return would be 7%. As long as your withdrawal rate is less than that, you should be good.
But, of course, equities only average 10%. What happens when they crash? What happens when they lose 20% of their value, as we see now? Or 33% like we saw in the COVID Crash? Or 50% like we saw in the Financial Crisis? That’s why we want bonds, right? For their stability.
Bonds as Stability
Bonds are more stable than equities. Because most people cannot watch their interest income be eroded by inflation and then redeem all their bonds at the end, they must sell them over time. Or, more commonly, they are invested in a bond fund that is constantly buying, selling, and redeeming bonds. Changes in interest rates and demand will cause fluctuation in bond prices and volatility in bond investments. Bonds are volatile, but less so than equities.
The thought goes, then, that you own bonds both for the interest income and for the stability. When equities go down in value, our bonds remain more stable. We can even rebalance at the bottom: sell some of our bonds that are hopefully up or only down 3-5%, and buy equities that are down 30-50%. We ride the equities back up and rebalance again after the recovery. By keeping the portfolio at 60%/40% equities to bonds, we can systematically buy low and sell high. Right?
Unless bonds bomb at the wrong time.
In this current market downturn, incited by uncertainty around Russia’s attack on Ukraine, inflation, rising interest rates, and general bad decisions, equities have gone down. Between its high in late December of 2021 and its (current) low point in mid-May, the S&P 500 lost about 18.5% of its value.
This would be a great time to rebalance. Our nice stable bonds can be sold and the proceeds invested into the dip. Or can they?
From their 2021 peaks to their 2022 (current) lows, here are the price returns of high-quality corporate bonds, as measured by these bond funds following the relative bond indexes.
Are you going to sell your long-term bonds at 25% down to reinvest at 18% down? Are you going to rebalance your intermediate-term bonds to capture a 2% difference in price? Are you going to sell your short-term bonds at a loss to arbitrage 11% when you may need that money for income if this season doesn’t recover quickly?
At at time when you need bond stability most, bonds bomb.
All my retirees have some bonds. All those bonds are taking a hit. The difference is that they don’t have 40-60% of their portfolio, earning the lower long-term real return and suffering when they need them most. They have 2-5 years of fixed income, as outlined in 3D Retirement Income. That’s about 10-20% of their portfolio. They have a much greater percentage of their portfolio earning the superior long-term returns of equities and generating the superior income.
And so should you. If you understand it and can stick with it with the help of a tough-loving and empathetic financial advisor, you should get your retirement income from Equities, not bonds. Because bonds generate less than half of the real long-term returns of equities, and when you need their stability most, it may not be there.
Because bonds bomb.
The reason most people have so much in bonds is not that it’s a better strategy. It’s because they don’t understand equity investing or are afraid of the volatility. A good strategy, a good plan, and a good guide can solve all those problems. If you don’t have them, what are you waiting for?
This article is educational only and is not intended to be investment, legal, or tax advice or recommendations, whether direct or incidental. Again, this is not investment advice. Consult your financial, tax, and legal professionals for specific advice related to your specific situation. Never take investment advice from someone who doesn’t know you and your specific situation. All opinions expressed in this article are the opinions of the people expressing them. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. RetireMentorship is not affiliated with any Registered Investment Advisor, Broker-Dealer, or other Financial Services Company.