Retirement Planning: Sizing up Bond Risks Part 1

Are bonds a wise addition to your retirement planning strategy? Learn the ins and outs in this blog series.

Between the Fed hiking rates, junk bonds faltering and one distressed-debt mutual fund freezing client withdrawals, it has been an extremely busy couple of weeks in the bond market. Considering bonds are often stockpiled as part of a retirement planning strategy because of their interest payments and overall lower volatility, the latest headlines may have some folks’ nerves frayed. But now isn’t a time for panic, it’s a time to assess where your assets sit and the advice you’re getting on your bonds.

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Are Bonds Safe for Retirement Planning?

Many investors buy bonds on the mistaken notion they are “safe.” But “safe” investments are the financial world’s equivalent of the Tooth Fairy, Santa Claus, and Hanukkah Harry.

The simple fact of the matter is all investments have risk, and someone telling you otherwise probably also has some nice oceanfront property in Arizona they’ll try and sell you. The key, then, is to understand what risks you face in your bond portfolio, and why. With that in mind, over the next few posts we’ll explore what’s afoot in the bond markets, add some professional perspective—and follow it all up with questions we advise you to ask your retirement planning professional.

Default Risk

In this first installment, we’ll explore your exposure to default risk. Financial media has been jam-packed with reports covering default, stressed bond prices and even fixed-income and hedge funds shutting their doors due to massive client redemptions.

The key questions here:

  • Which types of bonds do you own?
  • If you own bond funds, what types of bonds do your funds invest in?

The type of bond you own goes a long way to determining the degree and type of risk you face.

US Treasury Bonds

If you own US Treasury bonds, for example, you have very little (some say “no”) risk you won’t be repaid. That risk is technically called default risk and is one of the major risks any fixed income investor must consider.

Municipal Bonds

Municipal bonds (those issued by states, cities and other local government authorities) are also considered to be relatively low on the scale of default risk, but they aren’t default-risk free. Just ask Puerto Rico for more on that.

Corporate Bonds

Corporate bonds come in a few flavors.

    • Investment-grade corporates—those issued by high-quality firms—tend to have fairly low default risk, absent a recession.
    • High-yield, or junk, bonds have much higher risk of default. 
    • Distressed debt, the junkiest of the junk, has very high default risk. This distressed debt was what drove one highly publicized mutual fund to announce on December 10 it would freeze client withdrawals. Many of its top holdings were in firms that filed bankruptcy in the last two years. Two hedge funds employing similar strategies announced the same days later. The point here is you should know what you own.

Bond Performance

A related point is that not all bonds are faltering, so reacting categorically is likely an error. Bank of America / Merrill Lynch publishes a large series of bond indexes that can be useful to differentiate. Year-to-date through December 15, 2015, reports:

  • Treasurys are up slightly on a total return basis.
  • Municipals are up slightly more.
  • Investment-grade corporate bonds are down by less than one percent,
  • Non-distressed high-yield bonds are down -1.6%.
  • Distressed debt is down a whopping -38%.
  • Broader high-yield indexes that do not differentiate between distressed and non-distressed were down about -5.2%, heavily skewed by distressed debti.

Energy & Materials

Energy and Materials are also a huge story here. The high-yield bond market has a heavy dose of Energy and Materials debt—much more than their weight in the stock market. Falling commodity prices are pressuring many of them, impacting profitability and hitting bond prices hard. Energy sector bond defaults are up substantially in the last year, and the fear is there are more to come. If you are heavily exposed to Energy or Mining firms’ bonds, you could be taking a hit. Outside those areas, though, bonds are faring better and the risk of default is far lower.

Now that we’ve addressed the backdrop from a default-risk perspective, how might you assess your exposure? Here are some questions you should consider asking your retirement planning professional:  

  • What type of bonds am I invested in? Corporate? Treasurys? High yield?
  • How are you deciding which types of bonds to choose?
  • On a total return basis, am I up or down in the bonds I own?
  • If your bonds are down, ask your financial professional what he or she attributes that to?
  • What is my exposure to Energy and Materials in my total portfolio? In my bonds?

i Source: FactSet, as of 12/16/2015. All series based on Bank of America/Merrill Lynch’s indexes of US Corporates, Municipals, Treasurys, High Yields, High Yield Distressed and High Yield Non-Distressed Debt, 12/31/2014 – 12/15/2015.

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