Government Shutdown Ends, But Concerns Loom for Bond Investors

 government shutdown over bond risks loom

Everyone breathed a sigh of relief when the government shutdown ended this month. As InvestmentNews noted, bond yields are in flux, and the shutdown could have made things worse.

But while that ship has sailed, other risks still loom on the horizon. Industry analysts point to changing rates overseas, inflation, and predicted Fed rate hikes at home as potential bond market movers. A report from Deutsche Bank lists them, among other concerns, as 30 market risks to watch in 2018. And what's at the top of that report list? "U.S. inflation moving higher in 2018 Q2."

What's the Cause for Concern?

Why should bond investors be concerned? Here's something to consider. It’s well known that inflation is the enemy of the bond investor. Inflation erodes the value of a bond's fixed interest payment, resulting in one of the key risks investors can face… interest rate risk.

Industry analysts believe the bond market had priced in too-low expectations for Federal Reserve rate hikes in 2018. America’s strong economic backdrop and rising oil prices could translate into inflationary pressures, they report.

For many bond holders or bond-fund investors, this risk threatens the fixed-income portion of their portfolio. When you buy bonds, you must wait until they mature for the guaranteed payout. Investors, of course, are banking on the supposition that bond yields will be high—or sufficiently high enough—when they buy new bonds in the future.

Bond Values’ Impact on Retirement Income Objectives

Investors should heed how these pressures on bond values may affect retirement income objectives. One respected market scholar argues that bond funds don't belong in retirement portfolios.

Wade D. Pfau, Ph.D., CFA, a professor of retirement income in the Ph.D. program in financial services and retirement planning at The American College in Bryn Mawr, PA, has pointed out bond funds are volatile and subject to sequence risk.

"For a retiree meeting spending needs with portfolio withdrawals, bond funds might have to be sold at a loss if interest rates rise," he has said. "Income annuities sidestep this possibility (as, it should be noted, do individual bonds held to maturity). Interest rate risk becomes inconsequential, because spending amounts have been securely funded."

He goes on to say that, more importantly, income annuities can outperform bond funds as a retirement income tool because they offer mortality credits. "For someone wishing to spend at a rate beyond what interest rates can support, bond investments will essentially ensure that the plan fails," according to Pfau. "For example, someone who is spending at a 5% real rate from a bond fund earning a 0% real rate will run out of assets after 20 years. This is clearly a problem for anyone making it into year 21 of their retirement."

Managing Retirement Risks with Income Annuities

Pfau considers income annuities "actuarial bonds" that provide longevity protection unavailable with traditional bonds.

He writes: "Trying to meet a spending objective from a bond fund will inevitably lead to portfolio depletion while income annuities provide income for life. Income annuities are like a bond with a maturity date that is unknown in advance but is calibrated and [used] specifically to cover the amount of spending needed by retirees when they are alive to enjoy it."

Income annuities allow you to streamline the "income efficiency" of the fixed-income portion of your portfolio with guaranteed lifetime income. Your payouts are locked in no matter the interest rate environment or market activity. And, if liquidity and more control of your money are important to you, you can keep up with your income needs with a lifetime withdrawal schedule.

The downside with income annuities is that they are taxed as ordinary income, while bonds fall under the long-term capital gains tax rate.

Fixed Annuities and Bonds: 2 Different Paths to Retirement Income

While fixed annuities provide a set amount of income for life, bonds are designed to be held until maturity. Determining whether to include either, or both, of these vehicles in your retirement portfolio requires a careful assessment of your financial approach and goals.

The components of most retirement income portfolios have three sections. Conservative holdings in cash or cash equivalents on one end and high-risk investments, such stocks and mutual funds, on the other. Between these extremes are low risk, growth-oriented fixed annuities and bonds.

Annuity contracts may be tapped for guaranteed lifetime income that you cannot outlive. Bonds, by contrast, only pay interest at maturity, leaving investors at the onset of whatever new bonds are being offered once their existing bonds expire.

Beyond consistent lifetime income, some annuities are designed with an inflationary benefit that gives your annual income the potential to increase. This essentially gives you an income "raise" each year.

How valuable could this feature be? Inflation of 2% can erode retirees' purchasing power by more than $73,000 over a 20-year period, according to LIMRA. If inflation jumps to 3 percent, that number climbs to more than $117,000.

Creating an Income Portfolio Strategy for Your Retirement Future

A diversified portfolio can include both highly-rated bonds and fixed annuities offered by sturdy, high-rated insurance companies, depending on your goals, needs, and overall financial picture.

If you're ready for personal help, SafeMoney can assist you. Use our Find a Licensed Advisor section to connect directly with a financial professional. You can request a personal strategy session to discuss your needs and goals. Should you need a personal referral, call us at 877.476.9723.

Author: Ian

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