First the good news: Life expectancies are rising.
Now the better news: There are investments that may help you generate income so you’re better equipped to handle rising costs for expenses like health care and less likely to outlive your savings. Fixed income products like bonds can help once you’re retired and play a role in preserving the money you worked so hard to save.
The key takeaway is to understand the practicality of fixed income and prepare a portfolio in which fixed income investments generate some income.
“Preserving wealth and generating income through fixed income investments become even more important as life expectancy continues to go up,” said Craig Laffman, Director, Fixed Income Trading & Syndicate, TD Ameritrade.
Here are four things to understand about fixed income:
#1: Aspects and Traits of Fixed Income Products
Fixed income investments have a number of purposes for those nearing retirement or already retired:
- Preserve wealth - While fixed income prices may fluctuate, the end goal of fixed income investments is the hope of receiving the full face value amount when your investment matures
- Generate income - Fixed-income investments may provide a steady stream of income to help supplement your income or help fund your retirement
- Diversify your portfolio - Diversifying your investments across asset classes may result in less risk exposure for your overall portfolio
- Manage interest rate risk - While the risks of not receiving interest rate payments, or worse, never getting your money back, are quite real, the most everyday sort of risk with these securities is loss of value from interest rate changes. By creating a so-called “bond ladder” (see below) through staggered maturities, you can manage interest rate risk in both rising and falling environments and experience less exposure to interest rate volatility
#2: One Potential Advantage of Bonds Over Dividend Stocks
Over the last few years, as the stock market boomed, many investors began looking to dividend paying stocks instead of bonds for their income. This isn’t necessarily a bad idea, but it typically exposes you to higher potential risk. Companies can cut dividends or even ax them entirely, meaning there’s no guarantee of income. A bond, especially a U.S. government bond, is much more likely to pay you the income you’re promised when you purchase it.
Additionally, relying on dividends from stock holdings means exposing yourself to more of the turbulence of the stock market. While even retirees may feel they need stock market investments to help protect against inflation and provide growth opportunities, it’s worth considering whether this is the best place to go for income.
“If you’re entering or already in retirement, volatility in markets can have a material impact on your portfolio if you withdraw funds on a regular basis,” said Matt Sadowsky, Director of Retirement and Annuities at TD Ameritrade. “By having fixed income, you’re dampening volatility and the impact a down market could have when you’re taking money out of your portfolio.” The dampening of impact is based on having assets in both stocks and fixed income, meaning a downturn in the stock market won’t necessarily hurt your fixed income holdings.
#3: Fixed Income Doesn't Mean Risk-Free
Bonds do have their own risks, including the possibility that the bond issuer might default. The more risky the bond, generally the higher the coupon rate, meaning you get a higher yield on your investment. Less risky bonds, including U.S. Treasury bonds, tend to pay far lower yields than some types of corporate or municipal bonds. The 10-year U.S. Treasury bond was paying investors a yield of about 2.3% as of mid-July, while the average corporate bond paid a little under 5%.
When considering a bond, remember to do your research. Check what the ratings agencies have to say about it and know the risks, including that of default. Bond prices tend to have an inverse relationship to interest rates. So one of the risks of holding a bond is that, if interest rates rise, the value of your bond would likely decrease. If you hold the bond until maturity, you’ll still receive the full principal and the full coupon rate, but if you had to sell the bond prior to maturity, you could lose money.
#4: Countering Interest Rate Risk with Bond Ladders
Retirees who rely on fixed income needn’t necessarily let interest rate fears stand in the way. One way to help provide protection against rising rates (which typically accompany falling bond prices) is to diversify your bond portfolio by building a bond ladder. By holding longer term bonds, you can benefit from higher interest rates but the shorter term bonds give you flexibility in case rates rise in the future. Shorter term bonds mature sooner, which should enable you to reinvest at higher interest rates in a rising rate environment. So a bond ladder diversifies across time horizon to provide a balance of flexibility and yield. It’s something worth speaking to a financial professional about as you discuss your goals.
The Money Challenge of Living Longer
As life spans increase, making your nest-egg last a lifetime might become more of a challenge. Fixed income can help, especially in the early years of retirement, by helping reduce “sequence of returns” risk and take pressure off of equity investments, so that you can hold them longer before needing to sell and liquidate.
While many investors still need to grow assets through other investments, such as stocks, you might want to double-check your portfolio allocation to see how much is devoted to fixed income. The ultimate mix depends on a lot of factors, including your age, your other assets, and your spending needs, all of which you should consider discussing with a financial professional. Two TD Ameritrade checklists—one for retirees and another for those nearing retirement, might also come in handy.
While there’s no such thing as an investment without risk, fixed income investments have the potential to help those in retirement generate income over the long term.
We're Here to Help
Our Fixed Income Specialists can help you prepare your portfolio for a rising-rate climate. Reach out online, or call a Fixed Income Specialist at 800-934-4445.