Investors building retirement portfolios have many choices. They can consider stocks and bonds, savings accounts, certificates of deposit, real estate investment trusts, an index fund, mutual funds, and many others as they look to build a diversified portfolio using asset allocation. Annuities, whole life, and other insurance company products can add to the mix.
This can get very confusing, especially considering the impact of changing interest rates, the need for guaranteed income, setting up the right retirement account, and what happens in the stock market.
To download a retirement investment planning guidebook written by me, Jeff Camarda, click here
As one reviews and builds sources of income, from Social Security and elsewhere, both short term, long term, and other cash flow impacts on the nest egg need to be considered.
For CDs and especially bonds, maturity dates can be critical and should be scrutinized. As most of the rest of this article will highlight, though, bonds may not be a good choice to keep or buy going forward.
Stocks Paying More Than Bonds
Barron’s recently headlined that “Treasury Bonds Are Now Riskier Than Stocks” in the respected Up and Down Wall Street column. It said “the S&P 500 dividend yield is nearly 2%, while the 10-year Treasury yields 1.55%, marking a rare time when stocks yield more than government bonds.”
This could matter a lot for all investors, but especially for retirees with more limited timeframes.
The point is important: stocks in general – not just value or high dividend stocks – now look good compared to “the entire bond market: Treasuries, municipals, mortgage securities, and corporate bonds.
They look better not just because of the yield spread where stocks are actually paying a little more than bond interest. And that’s really saying something, since stocks in general like those in the S&P 500 include a lot of growth stocks that pay low or no dividends.
Looking at stocks with attractive dividends can be even more alluring. For instance, the iShares Select Dividend ETF (DVY), pays nearly 3.5%. Value hounds targeting high payers can do even better if they look for individual stocks. For instance Exxon pays nearly 5%, and many familiar names pay even more, some yielding 6.5% or even more.
Of course, stocks are not without downside risk. Stock investors should be prepared to stay in it for the long haul, since time tends to damp out the volatility and price swings. Longer holding periods are generally safer because of this.
Do Bonds Stabilize Portfolios?
To counter stock volatility, bonds are traditionally considered a portfolio stabilizer to even out stock price fluctuations and smooth out returns.
But bonds can have lots of downside risk, too, that many investors may not appreciate. When rates go up, bonds go down in value. Even holding to maturity does not protect the investor, since rates go up with inflation, and inflation will just eat into the lower interest return on bonds held to maturity.
This gets worse during times when rates are low, like now.
This danger is called interest rate or duration risk. It exists because of the inverse relationship between rates and bond values. When rates go up – as they may in the years to come – bonds drop in value. Rates have been falling and bonds have been in a soaring bull market for almost 40 years now, since about 1980. That’s a very long time, and many feel that what goes up, well, you know.
US rates are now close to zero, and some regions outside the US have negative rates, like Japan and Europe. This is perhaps why Barron’s suggested bonds now bear more risk than stocks. Rates have been really low before, but have not stayed there. When they went up, bonds pretty much got clobbered.
Some investors understand that part of the risk. But a more obscure danger exists as well, the risk tied to yield to maturity (YTM). As we talk to people, we find many that have bonds they’ve paid more for than they will get at maturity. Brokers can make a lot of money on bonds, and perhaps may stretch things a bit to get a sale.
Let’s use a simple example of a $1,000 bond that is offered new when rates are 5%. So the annual interest payment – or “coupon” – is $50. Later, let’s say rates drop to 3%.
In this toned-down example, that bond which originally sold for $1000 and paid $50/year or 5% interest would now have a market price of $1,667 because $50/year divided by a market price of $1,667 would show a current yield of $50/$1,667 or 3%, the new prevailing interest rate.
But the big problem here is the bond, purchased for $1,667, will mature to only $1,000, a pretty much guaranteed loss.
This example is exaggerated for emphasis,. It gets more complicated than this, of course, and is highly dependent on the number of years left to maturity. The longer, the worse. Here’s another example: for a 5% coupon bond with 30 years left in a 3% world, the market price might be around $1,392 for a bond that would mature to $1,000.
Investors buying bonds for more than maturity value – called premia or at a premium – almost never realize they are heading toward pretty certain “principle” loss as the bonds approach a payout value lower than what they invested. Of course, the bad news is reduced some by the higher ongoing interest payments – you actually get your “principle” back with each “excess” interest payment over prevailing rates (5%-3%), but many investors don’t understand really understand this, and may spend the “principal” along with the interest. Many don’t appreciate the capital loss growing each year as maturity approaches. They may be tempted to spend all the interest, not understanding they are basically spending “principal.” When they get back less than they invested, this could be a really big surprise, besides maybe bleeding assets still needed for a long retirement.
To make matters maybe worse for bond investors there could be tax disadvantages as well. The higher current interest is taxable at the highest marginal rates for non-IRA-type accounts, but the losses on maturity payouts are only deductible at capital loss rates, if at all, unless your tax person knows to amortize such losses each year as they occur. We bet many don’t.
Have Bonds Topped Out? Are Dividend Stocks The Way To Go?
There are a lot of reasons to believe that bonds have topped out and may be headed for a long, painful decline. There are probably good reasons Barron’s declared that “bonds are now riskier than stocks.”
The flipside, of course, is that stocks – hard as it may be to wrap your head around – may now be a safer pot for at least a good chunk of retirement assets.
There is no doubt that US stocks are close to record levels, and are priced at what some consider to be overvalued thresholds. But still, some parts of the market still look like real bargains, especially overseas, but even in the US.
Value stocks – the kind Warren Buffett talks about and invests in, which can be had on the cheap and which often offer nice dividend payments – have gotten really beaten down over the past ten years compared to growth stocks, and even indexes like the SP 500. While there have been some signs of a value turnaround lately, cheap stock investing has fallen so far out of favor many fans have given up or disappeared, which could be a sign of opportunity, since so few have been buying lately. Some pros, Camarda included, feel there’s a lot of great buys lurking in this space. We see some companies we think are really wonderful that still seem to be “on sale.”
Foreign value stocks may offer even more opportunity. They have gone down even more, and many offer attractive dividend yields. Many of these yields are even richer than US rivals.
Besides the higher income stocks may offer, they can potentially provide even more profits for patient investors. Stocks in sound companies can be expected to rise over time, but bonds are generally flatline investments which don’t grow much aside from interest rate effects. The long-term trend for stocks is generally up, for bonds, flat. But for periods of rising rates, the bond trend is down.
While it is possible that rates in the US may keep going down and or even go negative, we don’t think that’s really in the cards, and we think holding bonds can be dangerous going forward.
For the decades ahead, we believe assembling a portfolio of quality, high-dividend-paying stocks can make a lot of sense for retirement income.
To download a retirement investment planning guidebook written by me, Jeff Camarda, click here.