Analysts forecasting inflation have been crying wolf for a decade, leaving bond investors inured to warnings of rising interest rates or an inflation scare. Such complacency could prove troublesome for income-hungry retirees if they’re not well positioned.
The inflation outlook right now is sanguine, with indicators suggesting only a gradual uptick. What’s more, the global economy remains sluggish, and the Federal Reserve is in the midst of a “midcycle policy adjustment” where it says it won’t raise interest rates until a “material reassessment to the outlook.”
Against this backdrop, financial advisors say they have been more focused on helping retirees stretch a little more income out of yield-starved bond portfolios than guarding against fast-rising interest rates. And this approach worked like a charm in 2019, with the average long-term government bond fund tracked by Morningstar up 14%, high-yield bond funds up 12.6%, and the Bloomberg Barclays U.S. Aggregate Bond Index up 8.7%.
After such gains and recent signs of an upturn in the global economy, however, few bond analysts expect a replay. Many are on the lookout for the hints of inflation and rising rates that can turn bonds into losers—and be especially cruel to retirees counting on bond funds to provide income for immediate living expenses.
“Global growth will rebound in 2020, led by U.S. and China, putting upward pressure on global bond yields,” said Robert Robis, chief global fixed-income strategist for BCA Research, in a recent report (yields and prices move in opposite directions).
He expects rising inflation expectations to push bond yields higher in the first half of 2020, and political uncertainty from U.S. elections to cause bond yields to fall later in the year. Then, next year, he says he anticipates that a revival of inflationary pressure will force rates up, “sowing the seeds for a far more bond-bearish backdrop in 2021.”
Jack Ablin, chief investment officer at Cresset Wealth Advisors, says that retirees should keep a diversified portfolio of stocks and bonds, including dividend-paying stocks, for long-term income and growth. But for living expenses that must be covered for one to three years, “you want as much predictability as possible,” he says.
Many financial advisors do that with a cash stash—certificates of deposit, money-market funds, high-yield savings accounts, and sometimes ultrashort bond funds. Although earning less than 2% interest isn’t ideal, the idea is to make sure that any near-term income a retiree will need besides Social Security and guaranteed sources like pensions and annuities doesn’t get wiped out in either a stock or bond shock.
“I do worry about higher rates and inflation,” Ablin says. “Interest rates have been too low for too long.”
A look back to 2018 shows how an interest-rate shock can inflict damage on stocks and bonds.
When that year began, investors hadn’t expected the Fed to raise interest rates four times and ignite fears that higher borrowing costs for businesses and consumers would tip the economy into a recession. The pervasive worry in the markets became recession, rather than inflation. But interest rates shot up anyway, and funds invested in long-term U.S. government bonds lost 1.8% on average, according to Morningstar.
Corporate and high-yield bond funds—which are vulnerable if investors expect rising interest rates to crimp the economy—lost about 2.5% on average. Investors often buy Treasury inflation-protected securities funds and bank floating-rate loan funds to guard against inflation and rising rates, but with little inflation, those investments also incurred losses in 2018.
The lesson: Strategies used to protect bond investors from inflation may not work if interest rates go up when inflation is tame. In recessions, businesses can struggle to pay off their loans. So, high-yield bonds take the biggest hit, but better-rated corporate bonds and floating-rate loan funds can suffer, too.
Now, a slight rise of inflation is expected from the recent 1.8%. Economists surveyed by the Philadelphia Federal Reserve are expecting 2.1% headline inflation this year, 2.2% in 2021, and a continuation of that average to 2028.
Still, Joe Ramos, head of U.S. fixed income for Lazard Asset Management, says that predicting bond yields is difficult now because more is at play than inflation. Ten-year Treasuries have been yielding about 1.6%, but should be at 2.7% based on the strength of the U.S. economy, he says.
The distortion, he believes, comes from investors worldwide buying U.S. bonds to escape negative interest rates abroad, driving U.S. yields lower. If the globe shows better growth and central banks stop the negative rate push, U.S. rates could rise and leave people with losses in core bond funds.
But Michael Fredericks, head of income investing for BlackRock Multi-Asset Strategies group, doesn’t think there is enough growth in the world to push rates up substantially. The 10-year Treasury yield could go to 2% or perhaps 2.25% this year, but as growth remains subdued in the developed world and the global population ages, he says, it’s unlikely that long-term rates will rise to even 4% over the next five years.
Still, he isn’t trying to increase income by adding long-term bonds. “Longer duration is more sensitive to rates,” he says. “That brings up some important things for retirees” who might want to try to increase their income by buying long-term Treasuries.
He would not tell them to bail out of a diversified portfolio containing some intermediate-term bonds, because those bonds could provide protection in recessions. But he says veering toward shorter-term, highly rated bonds makes sense.
Short-term bonds are often the most resilient during periods when interest rates are rising, because they typically mature in one to three years and allow investors to get their money out and reinvest it at higher rates relatively quickly.
Long-term bonds, on the other hand, can be traps amid rising rates because the bonds may not mature for 10 years or longer, so they’re difficult to exit. If investors—including bond funds—want to escape low rates on their longer-term bonds before they mature, they can sell, but at a loss. Buyers won’t pay face value for a bond paying 2%, for example, if rates have risen and newer bonds yield 3% or 4%.
In 2018, short-term government bond funds were among the few segments of the market to eke out any gain, as the Fed raised interest rates and the yield on 10-year Treasuries climbed above 3%. By year-end, short-term government bond funds were able to provide investors a little solace. They gained 1.14%, while diversified long-term bond funds lost 3.26%, according to Morningstar.
But even though short-term government bonds ended up as the stars of the year, they did suffer temporary losses during the Fed’s rate hikes. The Bloomberg Barclays U.S. Treasury 1-3 Year index, which tracks U.S. Treasury bonds with one- to three-year maturities, fell 0.12% in September 2018 after a Fed rate increase.
Still, over the past 15 years, the Bloomberg Barclays U.S. Treasury 1-3 Year index has had the fewest negative monthly returns and the mildest downturns of any bond index, according to Morningstar. There were only three months when the index lost more than half a percent, compared with 32 for the Bloomberg Barclays U.S. Aggregate Bond Index, the index commonly used to reflect the broader U.S. bond market.
To know how exposed your bond funds might be to losses if interest rates rise, professionals use a measurement known as duration.
Simply put, it looks at how long a bond or bonds in a portfolio have to go until they mature. If durations are low, there typically are a lot of short-term bonds in the portfolio. When durations are high, it suggests portfolios have a big helping of longer-term bonds.
A bond with a one-year duration would probably lose 1% in value if rates rise 1%. On the other hand, if the duration is 10 years and rates rise 1%, the bond would probably lose 10% percent.
Paying attention to duration is especially important for retirees who plan to make withdrawals from bond funds. When individuals hold CDs or actual U.S. Treasury bonds, they know there are specific dates when they will earn interest and get all of their principal returned to them. But there is no such date for bond funds, and the last thing a retiree wants is to have to withdraw living expenses from a bond fund at a time when the fund is losing money.
For short-term bond funds, Morningstar’s top-rated exchange-traded funds are Vanguard Short-Term Treasury (VGSH), Schwab Short-Term Treasury (SCHO), and iShares 1-3 Year Treasury Bond (SHY).
Will Geisdorf, an ETF strategist for Ned Davis Research, changed his ETF model portfolio dramatically amid the interest-rate surge in 2018. At the beginning of that year, he had little in short-term bonds. But as interest rates climbed sharply, he pulled away from longer-term bonds and put more than 30% of his model bond portfolio into the iShares 1-3 Year Treasury Bond fund.
Recently, amid more stable interest-rate expectations, he dropped that to a 10% share of the bond portfolio. His largest exposure became SPDR Bloomberg Barclays High Yield Bond (JNK), at 40%, which provides more yield than government bonds and safe corporate bonds but could fall hard if the economy weakens. High-yield bonds tend to perform like stocks and fall in value during recessionary threats.
The rest of Geisdorf’s most recent model: 20% iShares iBoxx Investment Grade Corporate Bond (LQD) and 30% iShares J.P. Morgan USD Emerging Market Bond (EMB).
While the risk to long-term Treasuries would be high if there is an interest-rate spike, some bond-fund managers say the extensive period of low rates has also put investors at risk in low-rated investment-grade bonds. As investors chased higher returns in recent years, they pushed yields on the riskier corporate bonds to historically low levels—leaving relatively little income to act as a buffer against losses in a recession scare. Recently, BBB-rated bonds were yielding 3.09%, compared with the 5.49% long-term average.
In a webinar for clients in January, DoubleLine CEO Jeffrey Gundlach said that BBB bonds were among the worst investments now—and that he doesn’t like BB bonds, either.
As investment professionals debate whether inflation or interest rates will be a threat, there is a solution for retirees worried about threats to their income, says Christine Benz, Morningstar’s director of personal finance: Use a three-bucket strategy designed to generate income, regardless of whether stock or bond markets deliver a shock.
With this approach, money that will be needed for retirement expenses within about two years goes into an ultrasafe first bucket, to be invested in CDs, money-market funds, or high-yielding checking and savings accounts. Benz says the safe-stash allocation for a conservative investor already in retirement is about 12% of his or her overall portfolio. Then, the rest of the money is invested in a diversified portfolio of stocks and bonds in two other buckets.
The second bucket is a little riskier than the safe bucket. But it is still kept relatively low-risk in mostly bond funds, with a touch of dividend-paying stocks. The idea is to provide modest growth, but have the type of investments that will churn out income and gains over three to nine years, so dividends, interest, and some gains can be rerouted a little at a time back into the safe first bucket. The goal is to replenish the safe spending money repeatedly, so it does not get used up.
Benz suggests 5% in the Vanguard Dividend Appreciation ETF (VIG), 13% in Vanguard Short-Term Bond (BSV), 15% in Vanguard Short-Term Inflation-Protected Securities (VTIP), 20% in iShares Core Total U.S. Bond Market (IUSB), and 6% in Fidelity Floating Rate High Income (FFRHX). (The floating-rate fund and inflation-protected securities would help if inflation returns.)
To help the portfolio grow for the long run—13 years and beyond—Benz recommends a third bucket with an additional 23% divided between the Vanguard Dividend fund and Vanguard FTSE All World ex-US (VEU). The remaining 6% is split in half between Vanguard High-Yield Corporate Bond (VWEHX) and iShares JP Morgan USD Emerging Markets Bond (EMB).
With cash available for spending needs, Benz says, the goal would be for retirees not to touch stock and bond funds during market losses. If rising rates turned bond funds into losers, a retiree could leave the money untouched in the fund until the fund manager restored gains by buying new higher-interest bonds over time.
In a period of lengthy losses in stocks and bonds, a retiree could face a time when the first bucket was running dry, and the risk would be that he or she would have to cut back spending for a while or find another source of income, such as home equity. But in a pinch, Benz says, retirees could sell their short-term bond funds, and she suggests sticking with high-quality short-term funds to help limit losses. Typically, if those funds were experiencing losses, they would be relatively modest, she says.
Still, the biggest risk to individuals now is that a decade of good times has lulled people away from thinking about risks they might encounter from stock or bond portfolios.
Trying to talk with clients about risks now isn’t easy, notes Anthony Spangenberg, financial advisor for Savant Capital in Wilmette, Ill. “Everyone’s wearing rose-colored glasses.”
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