Think bonds are boring? Think again.

Today I'm talking about bonds and the safer side of your portfolio. Specifically, I’m going to explain why you likely need them, how they work, what causes interest rate risk, and how you can build a portfolio that’s protected from interest rate risk.

If you’re more than a decade out from retirement, you can likely skip this issue.

If you’re nearing retirement, or already in retirement, you’ll want to read this twice. It’s that important.

Why do I need Bonds anyway?

You’re probably thinking Jeb, bonds are boring, and they haven’t done well recently. Why are they so important in my portfolio?

To answer that, I want to start at the beginning. Stocks are typically the riskier (but higher return) portion of your portfolio, while bonds have lower expected returns and less risk.

Bonds are, at their simplest, a loan. That can be a loan to the government in the form of a Treasury bond, a loan to a local water district via municipal bond, a loan to a corporation via corporate bond, or maybe it’s a loan to a homebuyer, via mortgage-backed bonds.

Each of these work in a similar way. You buy a bond for a stated amount, known as the face value, say $1,000. The bond will pay a stated amount of interest, the coupon rate, for a stated period, the term. For example, this could be 5% annual interest for 5 years. At the end of the 5 years, you will receive back your original $1,000, also known as principal.

So long as you hold the bond till it matures, you’ll receive both the coupon payments and your principal back.

Like I said, this is the simplest version. There are plenty of caveats and entire textbooks written about these, so I admit to leaving a lot out.

You probably need bonds in your portfolio because of the safety they provide. For example, US Treasury bonds, some of the world’s safest bonds, are currently yielding 4% per year for a 5-year bond. You can use this predictable income as the basis for your retirement spending.

When I’m working with clients to build their retirement income plan, I typically recommend they set aside 3-5 years’ worth of withdrawals in safe investments.

The thought process here is pretty simple. Market corrections, when the index falls by at least 10%, happen every 18 months or so. Bear markets, a drop of 20% or more, occur every 4-5 years. You don’t want to HAVE to sell when the market is down to fund your normal spending, so you can avoid that by keeping your immediate spending needs in safer investments. The average Bear Market lasts a bit under a year, so by keeping 3-5 years’ worth of expenses in bonds, you can give yourself some breathing room.

I was using the same approach in early 2020, when Covid rocked the markets. As the market pulled back more and more, I began receiving worried calls from clients, inquiring about their portfolios. Many were worried that they would need to sell while the market was down 30+%, effectively locking in their losses.

It was a stressful time, but it was reassuring to say that they didn’t need to worry as they could pull their income from bonds for 4+ years and never sell a single share of stock.

Understanding Bond Risks

I keep using the terms fixed income and bonds interchangeably, but know that there are many, many types of bonds. Most bonds fall into one of the following categories:

· Government Bonds –long-term bonds issued by the U.S. Treasury with maturities of 10, 20, or 30 years, backed by the U.S. and considered very safe. The Treasury uses these to finance the actual operations of the government. Treasury Bills and Notes are shorter term, from a few days to 5 years in maturity.

· Corporate Bonds – short or long-term debt issued by corporations to fund things like acquisitions, capital investments, or inventory.

· Municipal Bonds - "munis," are debt securities issued by state, city, or county governments to finance public projects, offering investors steady interest income and tax advantages, as the interest earned is often exempt from federal, state, and local taxes.

· International Government Bonds - foreign-issued debt that offer diversification and potential gains from currency fluctuations or higher yields but come with risks such as political instability and exchange rate volatility, making them riskier investments.

· Agency Bonds - issued by government-sponsored enterprises or federal agencies, offer higher yields than Treasury bonds and finance public projects with a high safety level due to government affiliation. Mortgage-backed securities (MBS) are typically issued by government-sponsored enterprises (GSEs) such as Fannie Mae (Federal National Mortgage Association), Freddie Mac (Federal Home Loan Mortgage Corporation), and Ginnie Mae (Government National Mortgage Association), as well as private financial institutions.

Now I want to explain the risk that comes with bonds. Bond risks can be tricky, but there are essentially three bad potential outcomes that you need to know:

· You won’t receive your payment or your principal.

· You’ll be paid but the buying power of your payment will have gone down.

· You need to sell the bond and the value of the bond will have gone down or you can’t sell it at all.

Let’s break them down individually.

Credit / Default Risk

The risk that you won’t receive your payment is at the top of mind for most folks. If you make a loan, you expect to be paid back. Likewise, if you buy a bond that has a higher chance of default, or missing a payment, you should expect to receive a higher coupon payment to compensate you for the additional risk.

When you’re considering bonds, some categories have a higher credit risk than others. US Government bonds are generally considered to be the gold standard (I know, I know. We’re no longer on the gold standard) for safety, because they’re backed by The Full Faith and Credit of the United States. For that reason, Treasuries also have a lower yield than comparable corporate bonds.

You can compare the US’ yield to those of our neighbors to the south. Ten-year Mexican government bonds have a 9.17% yield, while US 10 year Treasuries are yielding 4%. There are other factors that go into international bond yield differences, particularly exchange rates risk, but rates are a proxy for a country’s financial strength.

You can minimize default risk by diversifying, across individual bonds and across bond types.

Inflation Risk

The risk that your purchasing power will be eroded is inflation risk. This brings up the concept of real interest rates, which is simply the rate you’re receiving (nominal rate) minus inflation.

The current real interest rate on the US 10-Year Treasury is 4% (nominal rate) – 3% (current inflation) = 1% growth per year in purchasing power.

Think about it like this. If you build your income strategy around withdrawing a specific dollar amount, an amount that is sufficient to cover your needs, and then inflation increases…that specific dollar amount won’t be enough anymore. You’ll need to adjust your spending or increase your income from other sources to keep up the same standard of living.

There are a few ways to hedge against inflation risk in a bond portfolio. Options like TIPS (Treasury Inflation Protected Securities) and Floating Rate bonds are one option. Another is to keep more of your funds in shorter term bonds, which allows you to reinvest them at a higher rate when they mature.

Interest Rate Risk

Bonds are funny things and they’re not particularly intuitive. When interest rates go up, the price of bonds go down. Crazy, right? If you’re holding a bond until it matures, this isn’t a big deal. If you have to sell early, you need to know how this works. Here’s why.

Some Treasuries are purchased directly from the US Treasury, but they’re also traded on the secondary market. Those traded on the secondary market are priced based on current interest rates. It makes sense, because why would someone pay the same amount for a bond that yields 3% as one that yields 5%? So, when interest rates increase, the price of bonds goes down.

Here's an example:

You purchase a 10-year Treasury bond for $1,000, you receive $40 per year (4% coupon), then you get your $1,000 back when it matures in ten years.

Things change and you need to sell it after 5 years. Interest rates have risen over that period and instead of 4%, they’re now 8%. To compensate for the lower yield, the value of your bond on the secondary market is now $600. If you hold it till maturity, you’ll still receive the full $1,000 though.

I know this is an odd concept. Keep an eye out, I’ll be posting a video with a better explanation early next week.

Lowering Your Risk With Bond Ladders

Here’s the approach I’m using to minimize risk for my clients. It works particularly well for those who are at or near retirement.

I build ladders using Treasury bonds. Specifically, I use ETFs which allow for simpler management and defined maturities, without owning Treasuries directly. That said, I do own individual Treasuries for some clients.

This approach involves purchasing Treasury bonds with varying maturities and systematically using the income from maturing bonds to cover the income needs of the following year. By doing so, I can spread out interest rate risk, while also minimizing the necessity of selling equities for income when the market is down.

For instance, rather than investing a lump sum in one bonds that mature at the same time, I break it down by income need. Depending on the client, I typically keep distributions needed for the year in a liquid money fund. Beyond that, I keep 3-5 years’ worth of distributions laddered. For a $1,000,000 portfolio that is taking 5% distributions each year, it might look like this:

You’ll notice that puts 25% of the portfolio in bonds, leaving 75% in equities. I consider this to be a pretty reasonable allocation for someone at or near retirement, so long as they have the ability to handle some volatility. I consider this a moderate-aggressive portfolio.

I should also mention that I don’t always go with Treasuries. It really depends on the specific client, income need, and their tax situation. For clients with significant taxable income, I might recommend using a municipal ladder instead. You can even do the same with corporate bonds if that’s preferred.

Bottom Line

If you don’t want to sell equities when the market is down, then you should own some bonds. If you watch the market compulsively and worry when stocks have a bad day, then you should probably own even more bonds. Bonds won’t give you higher returns, but returns aren’t the only important thing. Being able to sleep through the night without worry is so much more important than a higher return.

Has your advisor talked about how they approach the safe side of your portfolio?

Jeb