Better Without Bonds? How Retirees Should Think About Fixed Income Right Now.

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Bonds' recent rout has retirees wondering if fixed income still deserves a place in their portfolios. The answer? It depends.

Yields have climbed sharply in recent weeks on factors including the ongoing war in Iran and the resulting higher oil prices, inflation fears, deficit concerns, and a supply glut of bonds. The 10-year Treasury closed out the quarter at 5.29%, after its largest one-quarter gain since March 1994; the 30-year Treasury hit 5.64%, a level not seen since June 2002.

Prices, which move inversely to yields, have fallen. The Bloomberg U.S. Aggregate Bond Index has declined about 5.6% for the year, or 2.7% on a total-return basis. Today's prices largely reflect investors' expectations that the Federal Reserve will raise interest rates at least one more time this year, but if the pace of hikes exceeds expectations, prices could fall more.

"We have a Nor'easter blowing through the bond market," said Ed Yardeni, president of Yardeni Research, in a recent webinar.

That's the bad news for existing bondholders. The good news is that future total return prospects have improved. A bond's starting yield is a rough proxy for the total return investors can expect, and the aggregate index yields nearly 5%. That presents an opportunity for investors looking to add to their fixed-income portfolios.

Another silver lining is that yields are rising on money-market funds, CDs, and other cash instruments, providing some competition for bonds. "When interest rates go up for seniors, many see that as a positive," Yardeni said.

Should investors follow the playbook of Warren Buffett, famous fixed-income hater, and eschew bonds in favor of stocks and cash (including short-term T-bills)? Not exactly.

But it does pay to consider your goals and risk tolerance. Some retirees don't like to see volatility in the "safe" part of their portfolios. If you buy individual bonds and hold them to maturity, you can clip your coupon without worrying about price fluctuations. But you need north of $100,000 to create a diversified portfolio of individual bonds, advisors say, so that's not for everyone.

If there's a general consensus right now, it's that individual investors should avoid the long end of the yield curve. Yields get fatter the farther out you go, but it comes at a price of increased volatility. On Wednesday, the iShares 20+ Year Treasury Bond exchange-traded fund, for example, experienced its lowest close since 2002. It's down about 10.5% for the year.

Consider an allocation to alternatives. Rather than the traditional portfolio of 60% stock/40% bonds, consider a split of 60/30/10% alternatives or 60/20/20. In the latter, the 20% bond portion could hold a mix of short-term bonds, actively managed strategic income funds, and core bondholdings, says Mike McMeans, president of Silverling Financial in Columbus, Ohio.

Some advisors include gold and Bitcoin in their alternative buckets, although they don't throw off income. For an income-generating alternative to traditional bonds, the actively managed Janus Henderson AAA CLO ETF offers exposure to collateralized loan obligations, a securitized pool of loans; it is up 3.4% year to date on a total return basis and yields 4.6%. Some advisors also consider real estate an alternative. The Vanguard Real Estate ETF has a low expense ratio of 0.13% and a dividend yield of about 3.3%.

Finally, consider asset location-that is, where you hold your bonds. If they're in a taxable account, yields are subject to ordinary income taxes every year. "Bonds have no place in the taxable account of a high-bracket retiree," says Matthew Chancey, founder of Tax Alpha Cos. (Tax-free municipal bonds may be an exception.)

With a traditional IRA, you're taxed only on the specific amount withdrawn to meet your needs for the year. That gives you some flexibility to manage your taxable income to remain eligible for certain benefits while not triggering higher marginal tax rates or Medicare surcharges.

 

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