What’s So Great about Bonds?

The traditional safe haven for investors is one thing I see with just about every plan and I’m not sure I agree with such widespread use of this asset class. Bonds are a consistent source of interest payments and usually come with much less volatility than the stock market. For those reasons, bonds have been the go-to choice for risk reduction and the backbone of a balanced retirement portfolio.

Let me state for the record that I believe bonds are a fine investment, so long as they are used the right way and with full knowledge of the potential downside. If you use them the right way there really is no downside but there’s not a lot of upside either. My problem is not with bonds specifically, rather most people hold a substantial part of their portfolio in bonds but don’t understand the limitations.

So I’m going to point out the main drawbacks so if you decide to use bonds for retirement you will do so for the right reasons and as part of a well-designed strategy. There are two major issues that I see on a regular basis and I’ll explain both so you know what to avoid.

Bond Funds:

Most people don’t actually own bonds, but rather a fund that buys and sells bonds regularly. Minor interest rate changes cause holdings to constantly fluctuate in value. In a steady rate environment, you’ll get the same result as the actual bonds provide, steady interest payments and a stable account value. But rates have been anything but steady over the last several years. Bond yields hit a double bottom in 2015 and 2016, climbed steadily through 2018, and have started to decline again as concerns over Fed movements give pause to institutions who request long-term credit.

I’ve been talking to people about this specifically for the last five years. There are a lot of people who have no choice but to use bond funds given limited options inside a 401(k). There are also a lot of asset managers who choose bond funds over the laborious task of selecting a diversified portfolio of highly rated individual bonds.

After looking at several personal account statements recently, I’ve seen many bond funds that are down in value by as much as 20% over the last five years. Interest payments are steady but combined with the loss in account value the total yield is miserably low.  Safe assets are not necessarily the best choice when the value of those assets can fluctuate so dramatically. And we haven’t even seen rising interest rates yet. It’s certainly no place to be if you want or need to start drawing money from a portfolio either because you may be forced to realize those losses in account value.

Income and RMDs:

Above I established that if you are going to use bonds, use individual bonds and hold them to maturity. Don’t use a bond fund because interest rate risk is out of your control. This leads me to the next major issue with bonds and it comes when you have to pull money from your portfolio.

Right now a highly-rated 5-year bond is yielding just under 4%. It’s down from almost 4.3% in December but we can use the current rate since it’s a little simpler to calculate. Let’s assume a $1M portfolio that is split 50/50 between U.S. Stocks and Bonds.

The average initial Required Minimum Distribution (RMD) is about 4% and that’s equal to the average withdrawal for retirement income. So whether you are 60 and want to draw an income or 70 and required to take a distribution, the problem is the same.

4% interest on half of the portfolio produces $20K annually and that leaves you $20K short so where do you draw the balance? There are two choices, take dividends from the stock side or sell the principal of either stocks or bonds and that’s where the risk is.

Selling bonds exposes you to interest rate risk, which is the declining value of the underlying bond in a rising rate environment. Selling stocks may be beneficial at times but during corrections or bear markets, you compound losses by selling undervalued securities. Growth over time will be severely limited.

Dividends for the S&P 500 have averaged around 3% over time and that will still leave you a touch short of the withdrawal goal so at most times, selling principal on one side or the other may be necessary more often than not. It’s also worth noting that taking dividends for income and not re-investing them results in much less growth over time as well.

It’s not all bad news of course. There are plenty of stocks with stable performance that pay higher dividends than the average so it’s possible to exceed 4% withdrawal on the total portfolio without selling principal. But it takes a lot of work and specialized expertise. If you hire someone to do it the fees will take you under 4% so the result is the same.

Retirement planning is a tricky business as there are limitations to every strategy. I advocate using annuities in place of bonds for extended liquidity on the safe side of the portfolio without being exposed to interest rate risk. Anyone who knows me well realizes that I’ve run the numbers on either scenario over several different market periods. I tried about 50 different simulations just to write this post.

The results show that in a favorable market period, the annuity has a minor advantage. This is because with consistent growth you can always sell securities at high values and won’t often find yourself handling a serious decline. In a poor market return period the annuity has a significant advantage because it allows for greater principal withdrawals when the market is down, giving the stock side of the portfolio a chance to recover in value.

So what’s the answer? Since it all depends on how markets and interest rates perform then we don’t exactly know. But if both are the same when rates are stable and markets perform well and one is clearly better when rates are low and markets perform poorly, the correct answer is diversification. No single product or asset class is appropriate for every situation. Diversify risk and opportunity in order to optimize protection and maximize growth in all scenarios.


Further readings

Are Fixed Indexed Annuities a Good Investment?

Fixed Indexed Annuity Taxes

Who Shouldn’t Buy a Fixed Indexed Annuity

Last Updated on May 10, 2024 by Bryan Anderson