The Bond Investorâ€™s Dilemma
Yields on high quality bonds are at a 50 year low and experienced investors, who might have enjoyed 5%-10% yields on AAA bonds in the 1980s and 1990s, are now earning 1%-3%. This has a dramatic impact on retirement income and has created a dilemma for many investors: should I stay the course and accept the low yields (and the risk of having my bonds called) or should I look at other strategies to close the income gap?
Some investors have large retirement nest eggs (or current income from other sources) which affords them the flexibility to maintain status quo with their bond investments. Many others, however, are not so fortunate and need to seek higher yields in order to generate enough income to cover their monthly expenses. These investors are forced to change their approach, hoping that they will earn enough return in alternative assets to offset the loss in yield. Some classic examples investors are using to seek higher return are:
- Increasing Stock (Equity) Exposure
- Buying High Yield Bonds, Real Estate Investment Trusts (REITS) or Master Limited Partnerships (MLPs)
- Buying Private Pensions (Single Premium Immediate Annuities)
Every product or investment strategy has pros and cons and it doesn’t take an advanced degree to recognize that 4 out of the 5 examples above increase investment risk. And the fifth option, buying an annuity, is something that many investors simply will not entertain given the liquidity constraints of the products.
There are two core reasons why investors own bonds: to generate income and provide safety of principal. While high quality bonds continue to provide safety, today’s low rate/low yield environment has essentially changed the income calculus and made bonds much less attractive. In other words, while high quality bonds continue to act like an insurance policy in portfolios by providing protection against loss, the premium (yield) one receives has been dramatically reduced. Simply put, the cost of the insurance (bonds) has increased and investors need to think differently about risk profile, yield and protection. Furthermore, advisors that continue to recommend traditional portfolios that predominantly use bonds to buffer equity volatility and are charging fees for this advice, might need to rethink their value proposition. For example, if bonds are yielding 1.5% per year and an advisor is charging 0.5% for their advice, the advisor is earning 33% of the return (we are making the assumption that there will be little to no growth on the bonds over the next 5-7 years). Some would argue that this is not a fair revenue sharing model.
The ideal investment strategy will vary based on individual income needs and risk profile but, given the current low interest rate environment, it seems rational for investors to challenge the conventional use of bonds within a portfolio. In other words, investors should question whether it makes sense to keep or acquire bonds that are paying historically low returns in their portfolios.
If the low interest rate environment is a concern and/or you have general retirement income planning questions, please call or email your Citrin Cooperman Engagement Partner to discuss potential alternatives.
This document has been prepared for informational purposes only and is not intended to provide specific investment advice or recommendations to any recipient. The information contained in this commentary is subject to change without notice, represents statements of opinion which have not been independently confirmed, and Citrin Cooperman makes no representation or warranty as to its accuracy or completeness.
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