The most aggressive Federal Reserve rate-hiking campaign in decades crushed the bond market in 2022, sending the iShares Core U.S. Aggregate Bond Bond ETF down 13%.
After rebounding earlier in the year, bonds have produced more losses in recent days as yields climbed sharply. Bond prices decline when yields rise.
Investors buy bonds for safe income, not double-digit losses. But there is a silver lining to the bond market wipeout. Yields have risen to levels not seen in years, giving patient investors the opportunity to bolster portfolios with bonds with the potential for both high income and capital gains.
For retirees and those nearing retirement, the question is where in the wide world of fixed income should they invest? What’s the right duration? Short-term Treasuries—including 3- and 6-month T-bills—are sporting yields higher than 5.4%. That’s enticing. But if the Fed begins cutting rates in 2024, longer-term bonds will be the better investment.
Here are three things to keep in mind while constructing your bond portfolio.
1. Start Extending Duration
If you’re in or close to retirement and your goal is to generate income and reduce portfolio risk, “we have been suggesting investors move out in duration and buy intermediate-term bonds, in the five- to 10-year area,” says Kathy Jones, chief fixed income strategist for Schwab Center for Financial Research.
Jones suggests a laddered approach so investors can spread out various bond maturities over time. (A bond ladder is a portfolio of individual bonds that mature on different dates, designed to provide income while minimizing exposure to fluctuations in interest rates.)
Target the average duration for a laddered bond portfolio to around six years, Jones says. Those can generate a 5%-5.5% rate depending on how much credit risk you want to take. “That’s been the highest yield you could get in about a decade and the highest real rates we’ve seen in a very long time,” she says.
Jeffery Elswick, director of fixed income at Frost Financial Advisors, similarly recommends laddering bonds from two- to 10-year maturities, with an average maturity around five years. “You’re locking in a higher yield than what we’ve had for most of the last decade,” he says.
Elswick says it makes sense to take more duration risk—but not too much. “We’re recommending not having much exposure at the long end,” he says, since they have the lowest yields and highest risk. “You’d be giving up even more near-term income by investing in 30-year securities rather than 5’s and 7’s.” Short duration carries less price risk, but longer-duration bonds provide more yield and total return certainty—a crucial factor when you have to think about funding the next 20 to 30 years of retirement.
2. Shorter-term Bonds Look Great Right Now, but Don’t Forget Reinvestment Risk
Short-term Treasuries and money markets are sporting yields upward of 5%. Shouldn’t retirees park a good chunk of their fixed income portfolio in this corner of fixed income and take comfort in the safety and the sizable yield?
Actually, no. Consider reinvestment risk, or the risk of having to reinvest a maturing bond at a lower interest rate in the future. Essentially, these currently high yield levels are fleeting and likely won’t be as high down the line when your bond matures and you want to reinvest your money.
“If you think you’re going to roll over T-bills for the next five years at 5%, you may be disappointed,” Jones says. “What are you going to do if yields come down? Because that’s what the inverted yield curve is telling us—that the Fed is forecasting yields to fall.”
While rates may not drop in the next six months as the Fed keeps rates high to vanquish inflation, by staying short you will miss out on capital appreciation of longer-dated securities if rates move lower. Just as bond prices tumbled last year amid rising rates, they could soar next year amid declining rates.
Consider the likelihood that yields on T-bills and cash instruments have reached their peak. “If we’re right and the Fed has increased rates for the last time, all those types of securities and money-market funds have reached their maximum,” says Elswick. “They’re not going much higher in terms of the yield they’re offering.”
3. Inflation Protection Has Gotten Cheaper
Treasury inflation-protected securities, or TIPS—a type of Treasury bond whose principal is indexed to inflation and used to protect investors from inflation—are another option for fixed-income portfolios.
Retirees in general should have some type of inflation protection, and TIPS are one of the best ways to do that, says Amy Arnott, portfolio strategist at Morningstar, who adds that yields for TIPS are still attractive, especially if you stay with maturities of five years or less.
The market is pricing in an expected inflation rate of 2.3% now. “If you buy TIPS at this level, where the current real yield is about 2.12% on a 5-year TIP, you have kind of a built-in hedge in the event that inflation turns out to be higher than the market is expecting,” says Arnott. “I think that’s a real possibility—even though we’ve seen good inflation numbers recently.”
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