It sounds like a no-brainer for retirees in today’s 6% world: Lock into a high interest rate for as long as possible and go play golf.
The economy has a few more bumps in store for you, because for every “up” in financial markets, there’s a correlation that drags something else down. To wit, as bond yields go up, bond prices go down, which is what we’re experiencing now. But as interest rates go down, if that follows predictions, there will be repercussions, too. There’s never an easy score or a sure thing, even for investments like Treasury bills and bonds that are touted as risk-free.
“Risk-free can be a misnomer,” says Anthony Woodside, head of U.S. fixed-income strategy at asset manager LGIM America. “There’s duration risk. You have reinvestment risk. You’re always exposed to rates going up and down.”
One new worry on the horizon: Callable and convertible bonds and CDs. Conditions are brewing for a dip in interest rates, and corporations and other entities that issue debt have been preparing for this by issuing more call options than ever, and with increasingly shorter call windows.
“Some of the angst is stemming from the fact that the fixed-income portfolio has been getting hurt the last two years — 2022 was down significantly, and this year is similar negative total returns,” Woodside says. If you’re closer to retirement, maybe you don’t want to be exposed to higher duration, and maybe you want to avoid callable structures.
What is a callable bond?
When a bond is callable, that means that the issuer retains the right to buy it back from you at designated intervals. So you could buy a $1,000 bond for $950 that earns 7% for 10 years, thinking you’re in a stable investment for a long while — you’d make $35 every six months and get $1,000 at the end of the duration. But if interest rates dip, the issuer will call it back as soon as it can and redeem it at face value. Then they’ll reissue the debt at 5% or whatever the prevailing rate is. This works in much the same way as when a homeowner refinances when rates dip — except in the case of bonds, the issuer is the homeowner and the investor is the one who has to foot the higher bill. You won’t lose your principal, but the risk is that you’ll have to reinvest your money at a lower rate.
Treasury bills and bonds are not generally callable, but there are exceptions. Regardless, the longer the duration you hold on those, the more price and interest-rate volatility you will encounter. Retirees and near-retirees also hold lots of other fixed-income debt — like municipal bonds, corporate bonds, some CDs and convertible equities — that likely is at risk of being called if interest rates dip. For most of these, you have to really dig into the prospectus details to find the call parameters so you won’t be surprised by a notice from the issuer.
“Bonds are complex tools. Equities are complex too, of course, but most people know about buying Apple stock and getting a dividend. But with bonds, they aren’t very sure,” says Devin Pope, a certified financial planner with Nilsine Partners in Salt Lake City.
Pope says his clients generally use bond funds, but some larger accounts will invest directly in bonds — mostly in tranches of $100,000 or more, and at the direction of his company’s institutional bond desk. For the individual, researching bonds can be daunting, even though the conditions are supposed to be fixed and there are mathematical formulas to calculate the various yields.
How to manage your risk
Even if you hold your fixed-income investments primarily in managed products like bond exchange-traded funds or mutual funds, target-date funds or other managed portfolios, you can’t really escape risk. Your portfolio manager will handle the ins and outs of buying and selling, but the overall economic conditions will still affect the price of your shares in those products and the monthly yield. And you will not be immune to the anxiety of seeing your bondholdings in bright red, indicating losses, on your portfolio statement.
“It’s a paper loss — as long as it doesn’t default, and we’re not talking about junk bonds here,” says Pope. “You’ll get your money back, and we know there will be a positive return because of the yield. This is where there’s some safety and security with bonds, if you hold them to maturity.”
That’s where strategy comes in, says Maria Bruno, a certified financial planner and senior financial planning strategist at Vanguard. It matters in which accounts you hold different types of bonds, and you need a strategy for how you’re going to access them for spending.
“Getting income is a good thing for a retiree,” says Bruno. “They might not be as concerned about bond prices going down as much.”
But if you’re in the process of spending down your nest egg, it can be tenuous, because then timing matters. You don’t want to be put in a position where you have to cash out bonds that have dropped in price. That’s why Bruno recommends not just diversity in the traditional meaning of having a ratio of stocks and bonds, but also further diversifying your bond portfolio so that you have a range of durations and types. She also advises looking at where you hold those assets to maximize tax efficiency — municipal bond funds in taxable accounts and taxable bond funds in tax-deferred accounts, for example.
“Control what you can control,” says Bruno. “And focus on where we’re headed, not where bonds were last year.”
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