Retirees (or near retirees) heavily invested in bonds are likely in for a roller coaster ride that basic financial theory says may not end too well. With interest rates at historic lows due to the Federal Reserve’s $85 billion per month stimulus package, which is designed to keep rates low, bonds may be getting to a crisis point.
Made worse by the understanding that as interest rates rise, bond prices fall, investors are confronted with hard decisions. Facing the combination of falling bond prices and basement low yields, retirees especially need to evaluate their income generating strategies.
One solution is to purchase individual bonds and hold to maturity. Unlike many bond mutual funds which typically turnover bonds as they reach certain criteria, thereby potentially creating capital losses in a rising rate environment, individual bonds can be held till maturity at which time they should be redeemed for par value, barring any company liquidity issues. By doing this, investors lock in a specified rate of return for the portfolio that shouldn’t change regardless of interest rates. The key would be to utilize a yield to maturity calculation as opposed to a simple yield calculation. A yield calculation gives the amount of income the bond is paying out based on the price purchased now. The problem with a simple yield calculation, and the fix that yield to maturity provides, is many bonds are currently trading at a premium to par value (meaning you may pay more now than you will receive at expiration). While purchasing bonds at a premium sounds like a definitive negative, it is not necessarily the case as the increased interest you receive may offset this downside. Yield to maturity allows a fair comparison among bonds and represents the total return to the investor.
Another option is floating rate loans. Mostly used with financial firms or with small and midsize private companies, floating rate loans adjust to rising interest rates and typically also hold their principal much better than fixed rate bonds. While these bonds many times pay lower up front interest rates or are hard to access (in regards to private companies) these ma y provide an adequate hedge to rising interest rates.
Lastly, there have been numerous articles showing dividend yields on specific stocks or the general market and how they compare to bond interest rates. While moving assets destined for bonds towards stocks may increase current income, it almost certainly will increase the risk and volatility of your portfolio. If this is the chosen option, proceed cautiously as some basic hedging strategies may be appropriate to limit potential drops.