Vanguard Total Bond Market Index ETF, BND, is lower this year by about 4.75%. Vanguard's Long -Term Corporate Bond Index ETF, VCLT, is lower this year by a whopping 11.50%. Neither one would've been made flat this year if you include their full year's dividends from interest. So much for the safety and stability of bonds, right? Well, sort of.

 

You see, a good many of my clients are pre-retirees, new to retirement, and retired for a long time. They all want to know that they could count on a stable investment that pays enough interest to supplement or support their lifestyle throughout their retirement. The last ten years have made this task harder than ever due to the Federal Reserve's low interest rate policy, intended to stimulate the U.S. economy enough to recover from the Great Recession. It's forced many conservative investors into stocks that pay dividends and bonds with longer maturities and/or higher credit risks. In Wall Street parlance, that's called yield chasing. It works great while interest rates remain low and it destroys portfolios when interest rates go up. Adding insult to injury, without interest rates returning to post-Great Recession lows, it is hard to imagine any scenario in which investors could recover these capital losses.  

 

But even for the intermediate-skilled bond investor, diversifying one's bonds is just as difficult as diversifying one's stocks. If you own Johnson & Johnson stock, then maybe your next stock purchase should be Chevron or JP Morgan; anything but another big drug company. Similar with bonds; if you own a long term (11 to 30 years until maturity) bond, then maybe your next bond should be an intermediate term bond (5 to 10 years until maturity). Maybe you should by a Treasury bond, one issued by the U.S Government, that's guaranteed to pay interest and principal at maturity?

 

Let me introduce the word "duration" to this: Duration is a measure of a bond's sensitivity to interest rate changes. The higher the bond's duration, the greater its sensitivity to the change (also known as volatility) and vice versa.

 

Another, but imperfect, way to think about a bond's sensitivity to changes in interest rates is to think of longer dated bonds as more sensitive and shorter term bonds as less sensitive, i.e. more stable price. Other factors contribute to the volatility of bond prices, such as ratings from Standard and Poor's and Moody's and how much interest they are supposed to pay, called the coupon (interest rate).

 

There are a few advantages to investing in an individual bond, mainly you know exactly how much money you'll receive at maturity. But that is as much of a curse as it is a blessing. Think of it this way: the amount of money you receive from a bond at maturity will have less buying power in 10 or 20 years than it does now, due to inflation. Plus, if the bond trades lower between the times you bought it and the time it matures, that means you are losing money to inflation every single day that you own it. With just a 3% inflation rate, you'll lose half your purchasing power in about 25 years. Therefore, knowing how much you'll get back at maturity is not the end-all and be-all that people think it is.

 

Bond funds have advantages too; diversification and reinvesting of interest is simple to do. But you don't have the certainty of knowing how much money you'll receive for sure down the road because there is no set maturity for a bond fund.

 

So, what's an investor to do?

 

I'll share a few basic strategies with you:

1. For individual bonds, you could ladder them. This means buying bonds with consecutive annual maturities, i.e. maturing every year for the next 5 years and when the one that matures in 1 year matures, reinvest the principal into a new bond with a 5 year maturity. It's a compromise that allows for adjustments to changes in interest rates and inflation but it lowers your interest income because you didn't invest all of your funds into just the 5 year bond.
2. For bond funds, you can build a diversified portfolio with all different types of bonds and maturities. Since these bond funds won't actually have a finite maturity date, you could rebalance them periodically since their dollar amounts will fluctuate, some more than others. This way, you could stick with an appropriate risk/reward level and take advantage of price discrepancies between the bond funds.
3. A recent innovation within the bond world has combined the attributes of diversification of a bond fund with the maturity date of an individual bond. I use these to build highly diversified, laddered bond portfolios as well.

It's often been said that bonds are boring, but for most of my clients who invest in them, that's a good thing. 

 

If you're looking for a better way to save, invest, and plan for your retirement, click on the "Let's Talk" picture below to schedule a 15 minute phone call with me.