Gary Brooks: Bonds offer ‘safe’ haven, but at what cost to greater retirement wealth?

Stock markets receive a lot of attention, but the bond market represents more money in the U.S. and abroad. Total wealth held in the U.S. bond market, providing debt financing to companies and governments primarily, is about a third more than the total value of all U.S. publicly traded stocks.

Stocks historically have been far more volatile in their price movements but also have compensated investors more for accepting higher risk than bonds. Over the next several years, and possibly decades, bonds could present a different form of risk, in that the income they produce is likely to be minimal.

With interest rates at historically low levels, many bonds will not be able to generate meaningful income. The Bloomberg Barclays U.S. Aggregate Bond Index had a 4.25 percent average annual return over the past 15 years through the end of May. And this was in a market environment that was generally favorable for bonds.

Now, we are likely in a long-term transition to bond income so low that it may struggle to build real wealth beyond the impact of inflation. The 10-year U.S. Treasury bond had a yield of 0.66 percent at the end of May. The starting yield is a good indicator of the likely return over the life of a bond. Vanguard’s latest 10-year return projections for various segments of bond markets suggest probable returns under 2 percent per year, fractionally higher than expected inflation.

Interest rates are likely to remain low for a long time. With the federal government adding massive amounts of debt to fund pandemic relief and economic stimulus, the Federal Reserve could be incentivized to keep interest rates low to allow for low-cost repayment of that debt.

As the cost of borrowing has declined, corporations are increasingly issuing new bonds to raise money for operations. Last week, Amazon was able to find buyers for three-year bonds at 0.40 percent, the lowest yield ever on a three-year U.S. corporate bond.

There is rough precedent for this environment. In the 1940s and ’50s, bank deposits and intermediate-term Treasury bonds generally paid less than 2 percent. According to Ben Carlson, author of the blog “A Wealth of Common Sense,” from 1940 to 1979 the cumulative total after-inflation return of intermediate government bonds was -30.9 percent. From 1980 through 2019, it was 361.4 percent.

Individual investors have primarily only participated in the golden age of bond investing. Prior to 1980, very few individual investors were responsible for choosing investments. This was mostly pre-401k when most bond investors were pension fund managers and insurance companies. Now, many people are responsible for picking bond funds in their employer retirement plan or individual retirement accounts. For many, this is an emerging test of how to get the most out of the conservative portion of the portfolio.

If there is no catalyst for interest rates to increase meaningfully, what is an investor in search of income to do?

The academic literature regarding optimal retirement income has long suggested that retired investors utilize immediate or deferred annuities as a form of longevity insurance. There are many flavors of annuities, but generally, in the simplest cases, you give up future access to the capital you use to purchase the annuity in exchange for a lifetime income stream. The payments to you are made up partly of interest and partly return of your original investment. Because of this, payout rates are higher than if you were investing in a bond that paid income but also returned your principal when the bond matured.

Charitable Gift Annuities are another option that may provide relatively attractive income, support an organization or cause you feel strongly about and come with tax deductions, a triple win.

An effective use of annuities is to determine your essential needs budget and then subtract other income (such as Social Security or pension) and purchase a large enough annuity so the monthly payments fill the gap. With this amount guaranteed, you can then position the remainder of your investments to cover discretionary spending and work to outpace inflation over time.

Aside from annuities, you can seek higher income from bonds by purchasing bonds or bond funds with longer maturities or bonds of companies with lower credit quality. The longer duration and lower credit quality of a bond issuer provide access to higher interest but also introduce higher risk. Generally, the bond portion of the portfolio is not where investors should take many risks. That’s better reserved for stocks, where the probability of better compensation for accepting the risk is available.

Above all, be wary of complex engineered products like structured notes that are pitched as high-income, low-risk investments by brokers who deal in expensive financial puzzles.

Building a resilient portfolio and retirement income stream is important, but adaptability is an important second. It’s possible that interest rates could decline further, even going negative in the U.S., which would present a different set of challenges for the economy and investors.