Bond Investing for Retirement: Make Sure You Know the Risks

Ask the average investor where they should allocate the bulk of their assets when approaching retirement and some might say bonds. But, in our view, this is not necessarily the best advice. We refer to the bonds many investors use when in or approaching retirement as retirement bonds. Though bonds may have a place in a portfolio, your asset allocation in retirement should be informed by and aligned with your individual goals.

Traditionally, many investors associate bonds with retirement because bonds are thought of as a low-risk income source during one’s golden years. Many financial professionals recommend to those approaching retirement that the investor shift a portion of his or her portfolio from stocks and to bonds. While bonds are generally less volatile than stocks in the near term and can generate income, bonds still carry risks. 

An Overview of Bond Risks

The following list provides an overview of some of the different risks associated with bonds.

Default Risk:
The bond issuer may be unable to pay back their debt obligation. The less creditworthy the issuer, the higher their bond yields could be. The extra yield is often a way of compensating investors for taking on the extra risk. Further, the grades from agencies, such as Standard & Poor’s, Moody’s and the Fitch Group, are sometimes based upon criteria which may not fully reflect a bond’s default risk.

Liquidity Risk: Many corporate and municipal bonds trade infrequently, making them difficult to price and sell. If you decide to sell a thinly traded bond, the lack of liquidity may mean selling at a discount.

Interest Rate Risk: Interest rates and bond prices are negatively correlated, so selling a bond before it matures in a rising interest rate environment could cause a significant loss.

Re-investment Risk: Holding a high-coupon bond until maturity may seem like a solid strategy, but many bonds come with a provision known as “callability,” whereby the issuer can redeem (“call”) a bond early. Often, an issuer will call a bond as interest rates fall, which means, as the investor, you may have to replace the called bond with a lower yielding one.

Inflation Risk: If inflation rises, holding a bond to maturity will erode the purchasing power of the interest you receive. In addition, the principal you receive at maturity will be worth less than when you purchased the bond.

Estimating tax liability can be complicated as well, due to the differences between the different types of bonds, how they were purchased, and the specific tax treatment of the interest received.

Lengthening Investment Time Horizons

People are living longer lives on average. Chances are you may live 20 or 30 more years beyond retirement. So, for the retirees who want to continue growing their portfolio after retirement—to leave money to a spouse, heirs, charity or otherwise lengthen their portfolio’s time horizon—heavily weighting your assets toward bonds will make it more difficult to achieve the growth goal in the long run. Simply, over longer periods, bond returns have shown more volatility and lower returns than stocks.

Exhibit 1: 5-Year Time Horizon

This illustrates another risk associated with bonds—falling short of your long-term investment goals. While stocks tend to be more volatile than bonds in the short term, if you want your assets to meet your goals in retirement, stocks will likely need to be a substantial part of your portfolio. In our view, bonds’ purpose in a retirement portfolio often is to help mute some of the short-term volatility associated with stocks. However, much of the long-term growth of your portfolio will likely come from stocks and not from retirement bonds.

Considerations When Choosing Bond Investments

For those bonds that you choose to include in your retirement portfolio, there are a number of factors to consider, including:

What types of bonds can you invest in?

  • Government Bonds: Also known as “sovereign bonds,” they are issued on behalf of a national government (The United States Treasury, for example).
  • Municipal Bonds: Sometimes called “munis,” these bonds are issued by states, cities, counties, and other government entities. In general, the interest on a municipal bond is free from federal tax.
  • Corporate Bonds: These bonds are issued by a private or public company.
    • Investment-grade corporates: Bonds issued by high-quality firms tend to have fairly low default risk.
    • High-yield, or junk bonds have much higher risk of default.

What are the retirement bonds’ characteristics?

  • Yield: The amount of realized return on a bond.
  • Duration: A bond’s approximate price sensitivity to changes in interest rates.
  • Maturity: The time from issuance until the principal of the bond is paid back.
  • Coupon: The annual amount of interest paid on a bond, usually expressed as a percentage or coupon rate.
  • Issuer: Who is issuing the bond (see above).

Before selecting a bond for your portfolio, make sure you understand how its price might respond to changes in interest rates.

Despite the complexities involved in choosing retirement assets, the good news is that you don’t have to do it alone. At Fisher Investments, we have helped thousands of clients with retirement income planning. If you are concerned about your current asset allocation or you would simply like a second opinion about a bond, download our Definitive Guide to Retirement Income or contact us for more information.