Are bonds a wise addition to your retirement planning strategy? Learn the ins and outs in this blog series.
This post is the third in a series of posts assessing how American retirement investors should think about risks in the bond market, particularly in light of recent news. You can click here for the first post on default risk and here for the second, regarding interest-rate risk.
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A ton of pixels have been spilled in recent months regarding bond market liquidity—the ease with which bonds can be converted to cash without greatly affecting the price. It has received so much coverage one financial writer, Bloomberg’s Matt Levine, has jokingly devoted a section of his daily news roundup to it under the sub-heading, “People Are Worried about Bond Market Liquidity.” Now, most of the concerns publicly stem around this as a systemic risk to the financial system—and are overblown—but there is a takeaway here for people creating their retirement planning strategy anyway.
All these headlines could beneficially start a conversation between you and your retirement planning adviser about the liquidity of your bond investments. Many bonds simply do not trade like stocks, and the more exotic you get in the fixed income market, the more risk you take that you can’t quickly and easily redeem without taking a big haircut.
The Type of Bond Can Affect Retirement Planning
As with so many aspects of the bond market we’ve discussed in this series, the type of bond matters a heck of a lot here. Treasury bonds are about as liquid as an investment comes. If these are in your portfolio, you needn’t worry much about your ability to sell them. (You can worry about other things, like interest-rate risk and the concern your return may not keep pace with inflation.) They trade nearly every second of the day and have a vast pool of potential buyers. Liquidity is a key positive feature of Treasurys, one reason global central banks hold them in droves.
But after Treasurys, things get a little dodgier. There are literally millions of unique bond issues globally, and not all of them trade frequently. Getting pricing information on these bonds is not as simple as going to Google Finance and punching in a ticker. Many times, you’d need to call your financial professional, who would in turn have to place a couple of phone calls or access a specialized computer system showing current bids for the bond.
Municipal bonds range widely in liquidity, and if you are a heavy buyer of munis to fund your retirement, you should be apprised of their liquidity up front.
- Investment-grade corporates trade more, and some of these are even exchange-listed, but they are still not as liquid as Treasurys or stocks.
- High-yield corporate debt, considering the higher risk, tends to have fewer buyers and trade less than investment-grade bonds.
- Distressed debt may rarely trade. Some of these issues go long, long stretches without changing hands. If you own such bonds and want to liquidate, the price you receive is likely a question mark until the buyer is actually found.
Beware of Frozen Assets in Your Retirement Planning
You might think this is all an esoteric, theoretical question, but it has practical applicability. For example, investors in the Third Avenue Focused Credit Fund—a distressed debt mutual fund—just found out the hard way on December 10 that these bonds aren’t liquid. The fund froze redemptions.
This isn’t unique, either. In the period preceding the 2007-2008 Global Financial Crisis, quite a few retirement investors bought Auction-Rate Preferred Securities from banks, a type of bond they were told had cash-like liquidity features with higher returns. That statement should have sent off alarm bells, as it is impossible in efficient markets. But for many, it didn’t. When the financial crisis hit, the market for these products dried up near totally. Some retirement investors had their funds locked up for months, if not years. Liquidity matters.
Are Bonds Safe for Retirement Planning?
At the outset of this series , we reminded retirement planning investors that thinking bonds are “safe investments” is just buying into Wall Street’s fairy tales. There are no safe investments. Everything has risks. For this reason, you must diversify.
Yes, this means in bonds, too. Many bond investors eschew diversification, thinking it’s unnecessary. Balderdash. If you are investing in bonds, having big, concentrated positions in a few is a mistake. And remember: one issuer (company, municipality, etc.) can issue multiple different tranches of debt. This may or may not defray default risk. While bond funds offer immediate diversification by issuer, it’s up to you or your adviser to spread them across various types of bonds to defray higher-level risks. Failure to do so can over-expose you to some type of risk—liquidity risk, default risk, interest rate risk or other.
With that in mind, ask your retirement planning professional:
- How many different bond positions am I invested in? Are they from the same issuer or different ones?
- If they are from the same issuer, would the bonds be treated the same or differently in the event of default?
- What percentage of your assets are tied up in debt from each issuer?
- If you own bond funds, do the holdings overlap by issuer type?
- Ask your adviser how quickly he or she could convert your bonds to cash, in the event that was necessary?