Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With the Fed raising rates to try to get in front of inflation, lot of retirees are wondering if it really makes sense for them to be holding bonds. I'm here with Christine Benz. She is our director of personal finance, and she is going to make the case that retirees probably still want a bond allocation.
Christine, thanks for joining me.
Christine Benz: Great to be here.
Glaser: So, let's talk about why you would want to hold bonds right now. If you do have potentially inflation going higher, if you have rates going higher, both of those are bad for fixed-income holders, why is this something that investors should consider at all, particularly retirees?
Benz: And add in another reason why people don't like bonds is that yields are really low right now. In fact, you may be able to earn a higher yield on a high-yielding equity portfolio than you can earn on a high-quality bond portfolio. So, definitely, there's a lot of investors questioning the standard rules of thumb about holding bonds as retirement approaches. I still think they make sense as part of pre-retiree and retiree tool kits. And even as a percentage of the allocations for investors, who might be in there, say, late 40s and 50s, I think, some high-quality bond exposure makes sense.
The key reason is, especially as your spend-down from your portfolio draws near, if it's already upon you, you just want to have a portion of your portfolio that will hold steady or potentially even gain a little bit of ground in an equity market sell-off. And that's something--that's a relationship we've typically seen from high-quality bonds relative to stocks that often times when we see these big equity market shocks, we actually see high-quality bonds gain a little bit of ground.
And I think focusing on your spending horizon is really, really important. So, if you have a portion of your portfolio that you expect to spend during the next decade, even though certainly equity returns have been much better than bonds, much better than cash over the past, say, eight years, the virtue of holding bonds is that they're much more likely to deliver a positive return over shorter holding periods. So, equities, even though they've been pretty reliable return-generators over periods of 10 years or more, once you shorten that time horizon, equities are much less reliable. So, roughly 20% of the time in rolling three-year time periods, we see equities have losses. So if your time horizon is shorter, if your spending horizon is shorter, you need to hold some cash, you need to hold some bonds.
Glaser: If stability is important, then why don't you just hold all cash? What's the point of having that bond allocation?
Benz: It's a good question and one that investors have been asking for a good seven years now as we've had this expectation that rates have to rise sooner rather than later. Unfortunately, there's been an opportunity cost for investors who have hunkered down in cash in lieu of bonds even though we've seen interest rates tick-up a little bit recently, and that's hurt bonds over this equity market rally over the period since the market--since the economy has begun to recover, we've seen bonds outperform cash over that period.
So, there's an opportunity cost at various points in time. There's also the risk that with cash yields as low as they remain today, that you may not be able to keep up with inflation with a sizable cash allocation. So over slightly longer time horizons, I think it's reasonable to expect bonds to outperform cash.
Glaser: Looking at rising rates, we hear from investors, who say, well, if the bond fund is going to lose in a rising-rate environment, I would just buy an individual bond I'll hold it to maturity that won't be impacted by changes in rates. What are some of the pros and cons of a strategy like that?
Benz: There's a lot to like about that strategy from the standpoint of, if I buy a bond from a high-quality issuer, it makes good on its payments to me, then I'll have every bit of the money that I put in at the beginning, at the end when that bond eventually matures. So, I certainly see the appeal.
The big trade-off--well, I think there are two big trade-offs to holding individual bonds versus buying some sort of a bond fund portfolio--where admittedly you don't have that guaranteed return of your principal at the end of your holding period. But the reason that I like the idea of holding a bond fund is that you get more diversification than you can build as a smaller investor with individual bond holdings.
You also have the opportunity to participate in higher yields as they come online. So, if I am taking my money today and putting it into some individual bonds, I'm not going to experience a variety of interest-rate environments. Whereas the bond fund manager through the bond portfolio can buy higher yielding bonds as they come online.
So, I think it's a trade-off. I guess, my general message is, while high-net-worth investors might be able to do well with individual bond portfolios, I think most investors should stick with bond funds because of that diversification, because of that ability to participate more fully in varying interest-rate climates.
Glaser: How do you calibrate how much of your portfolio should be in bonds, particularly given where equity valuations are today. You might not want to be overweight equities either.
Benz: That’s right. I think it really does make sense, especially as retirement draws close, to think about your spending horizon for your portfolio. So, as you know, I'm a big enthusiast in this bucket strategy. The basic idea is that you are segmenting your portfolio by your expected spending horizon.
So in all of my model portfolios, I have assumed one to two years worth of living expenses in true cash instruments, the next eight years worth of living expenses in bonds, and the rest of the portfolio, so for years 11 and beyond of retirement, those can go into equities. And the net effect of that strategy is for new investors, new retirees, it doesn't mean that they'll have even the majority of their portfolios in bonds and cash. In fact, they'll have the majority of their portfolios remaining in stocks because they still have a nice long time horizon in retirement.
So an example would be, say someone has $1 million portfolio, and they are spending $30,000 from it a year. So just a 3% spending rate. If they are using some version of a bucket portfolio, they might have one to two years worth of cash, one to two years worth of living expenses, three to 10 years worth of bonds, and then the remainder of the portfolio in stocks. For such an individual with a 30-year spending horizon, that would mean that 70% of the portfolio would actually still be in stocks, but they have the front end of the portfolio in safer securities, where if we encounter some sort of really rough equity market, they will not have to touch the equity piece.
Someone with a shorter time horizon using a similar spending rate, so maybe an 85-year-old with say a 10-year anticipated spending horizon in retirement, with a $300,000 portfolio also using a $30,000 spending rate, that person too would have $60,000. So $30,000 times 2 earmarked in cash. He or she might hold the remainder of that portfolio in bonds. So much more bond-heavy portfolio for that person with a shorter spending horizon. So I think it really makes sense to right-size your asset allocation based on your spending horizon. I think as retirement draws close, rules of thumb really don't cut it. One hundred minus age, whatever it might be, really take the time to customize your asset allocation based on your anticipated spending needs.
Glaser: We've been talking about bonds, kind of this monolithic group, but of course, they are not. There's different types of bonds that you can hold. For most retirees, pre-retirees, is it just core bond funds they should be looking at? Or are there other parts at the bond market that are worth exploring?
Benz: I would weight the majority of a bond portfolio toward a high-quality bond portfolio. That's going to give you the best diversification characteristics relative to your equity portfolio. So, here we are talking about high-quality short and intermediate term bond funds.
Anytime you are stepping into any of the fixed-income categories that offer higher yields, but also higher volatility, I think you are getting a fund or an investment type that is going to act a lot like your equity portfolio. So, it won't give you those diversification characteristics. It won't tend to hold its ground or maybe even go up a little bit in those equity market shocks.
So here I'm talking about high-yield bonds, emerging-markets bonds, maybe multisector bonds. A lot of the categories investors have really liked amid this low-yield environment, I would say, own them, but own them as a fairly small share of your portfolio. Plain vanilla, high-quality bonds are really what you are looking for if you are looking for that ballast for your portfolio.
Glaser: Christine, thanks for joining me today.
Benz: Jeremy, great to be here.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.