If you ask the average investor where they should allocate their assets when approaching retirement, they might say bonds. This is not necessarily the best advice. In retirement or nearing retirement, many investors use retirement bonds. It is important to align your asset allocation in retirement with your individual objectives, even if bonds are part of your portfolio.
Traditionally, bonds are associated with retirement due to their low-risk nature. Financial professionals recommend that investors approaching retirement shift a portion of their portfolios from stocks to bonds. Despite being less volatile in the near term and able to generate income, bonds still carry risks.
Bond Risks: An Overview
Below are a few of the different risks associated with bonds.
Default Risk:
Bond issuers may be unable to pay back their debt obligations, and bond yields are higher when an issuer is less creditworthy. In many cases, the extra yield compensates investors for taking additional risk. A bond’s default risk may not be fully reflected in the grade provided by agencies such as Standard & Poor’s, Moody’s, and Fitch.
Liquidity Risk:
Bonds issued by corporations and municipalities infrequently trade, making pricing and selling difficult. Thinly traded bonds may require you to sell at a discount due to their lack of liquidity.
Interest Rate Risk:
When interest rates are rising, selling a bond before it matures could result in significant losses due to the negative relationship between interest rates and bond prices.
Re-investment Risk:
A high-coupon bond may seem like a good strategy, but many bonds have a provision known as “callability,” which allows the issuer to redeem (“call”) a bond early. Bonds are often called by issuers when interest rates fall, requiring investors to replace them with lower-yielding bonds.
Inflation Risk:
Bonds that are held to maturity will lose purchasing power if inflation rises. Furthermore, the principal you receive at maturity will be less than when you bought the bond.
Estimating tax liability can also be difficult due to the differences between the types of bonds, how they were acquired, and the specific tax treatment of interest.
Lengthening Investment Time Horizons
On average, people live longer lives, and there is a good chance that you will live 20 or 30 more years after retirement. Retirees who wish to grow their portfolio after retirement, to leave money to heirs, charities, or otherwise lengthen their portfolio’s time horizon, will find it more challenging in the long run if they heavily weigh their assets toward bonds. Bond returns over longer periods have shown more volatility and lower returns than stock returns.
Another risk associated with bonds is falling short of your long-term investment goals. In the short term, stocks tend to be more volatile than bonds, but if you want your retirement assets to meet your goals, stocks must be a significant part of your portfolio. Bonds may help mute some of the short-term volatility associated with stocks in a retirement portfolio. However, your portfolio’s long-term growth will probably come from stocks, not retirement bonds.
Bond Investment Considerations
Bonds that you decide to include in your retirement portfolio should be considered based on the following factors:
Investing in bonds: what types are available?
- Government Bonds: Also called sovereign bonds, they are issued by governments (such as the U.S. Treasury, for example).
- State, city, county, and other government entities issue municipal bonds, commonly called “munis.” Municipal bonds do not incur federal taxes on interest.
- Corporate Bonds: Bonds issued by a private or public company.
- Investment-grade corporates: High-quality companies tend to issue bonds with low default risk.
- High-yield, or junk bonds, are more likely to default.
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What are the characteristics of retirement bonds?
- Yield: The return realized on a bond.
- Duration: The degree to which a bond’s price is affected by changes in interest rates
- Maturity: The date the bond’s principal must be paid back.
- Coupon: A bond’s annual interest rate, usually expressed as a percentage or coupon rate.
- Issuer: The person or company issuing the bonds (see above).
Understanding how bond prices may react to changes in interest rates is important before selecting one for your portfolio.