Where to Go When Bond Yields Are Low

by | Apr 6, 2016 | Investing | 0 comments

Whether you’re retiring from a military career, a civilian post, or a culmination of both, creating a reliable retirement plan for you and your family can be challenging in any market climate. It can be especially tricky in today’s low-interest-rate environment.

When bond yields are low, the traditional technique of investing your capital and living only off the income begins to lose its fire-power. In a future post, we’ll discuss total-return investing, the strategy we typically advise as a best practice when planning for a satisfying retirement. But first, we want to explain why we do not recommend two other popular tactics we see investors using to try to prevent today’s low interest rates from consuming their retirement income. These include: (1) Bulking up on dividend-yielding stocks and (2) Shifting to high-yield (junk) bonds.

Dividend-Yielding Stocks: The Operative Word is “Stocks”  

We understand why dividend-yielding stocks seem like a tempting way to enhance your retirement income, especially when interest rates are low. You buy into select stocks that have been spinning off dependable dividends at prescribed times. The dividend payments appear to leave your principal intact, while promising better income than a low-yielding short-term government bond has to offer. Safe, easy money … Or is it?

It’s common for investors to mentally account for a dividend payout as if it’s found money that leaves their principal untouched. In reality a company’s dividends have to come from somewhere. That “somewhere” is either the company’s profits or its capital reserves. This means your division between capital and income is not being as neatly preserved as you might think.

In addition, dividend-yielding stocks may not be as sturdy or as appropriate as you’d like for generating a reliable retirement cash flow. Even if those stocks have dependably delivered their dividends in the past, there’s no guarantee they’ll continue to do so. Dividend stocks may offer a slightly more consistent cash flow than their non-dividend counterparts, but at the end of the day, they are still stocks, with the usual stock risks and expected returns.

Bottom line, our capital markets rarely offer a free ride. If you’re taking stock dividend income today, you’re likely paying for it in the form of lower share value moving forward. And if you’re invested in the stock market, you are exposing your nest egg to all the usual risks (and expected returns) that comes with that exposure. That’s how markets work.

Shifting to High-Yield (Junk) Bonds: An Inappropriate Trade-off

We can see why it’s appealing to try to have your bonds pull double-duty when interest rates are low: protecting what you’ve invested and delivering higher yields. This is probably why some investors try to move their retirement reserves into high-yield, low-quality bonds when higher-quality bonds aren’t delivering as hoped for. The problem is, the more you try to position your fixed income to fulfill two essentially incompatible roles at once, the more likely you will underperform at both.

Like any other investment, bonds don’t offer higher expected returns without also exposing you to higher risks. So, just as we do with your stock holdings, we must identify the best balance between seeking higher bond yields while keeping a lid on the credit and term risks involved.

With stocks – Taking on added stock market risk has rewarded stalwart investors over time. The evidence is compelling that it will continue to do so moving forward (assuming you adopt a well-planned, “buy, hold and rebalance” approach as a patient, long-term investor).

With bonds – Taking on extra bond market risk is not expected to add more value than could be had by building an appropriately allocated stock portfolio. Moreover, it is expected to detract from your bond holding’s primary role as a stabilizing force in your total portfolio … and it often does so just when you most want to depend on that cushioning stability.

For example, in “Five Myths of Bond Investing,” Wall Street Journal columnist Jason Zweig dispels the myth that “investors who need income must own ‘bond alternatives’” (such as high-yield bonds). He cites BAM ALLIANCE Director of Research Larry Swedroe, who observes that “popular bond alternatives … provide extra income in good times – but won’t act like bonds during bad times.”

Given these insights, logic dictates: If you must accept higher risks in search of higher returns, take those risks on the equity (stock) side of your portfolio; use high-quality fixed income (bonds) to offset the risks.

Beyond optimizing your bond portfolio with the right kind of bonds (high-quality, short- to mid-term), and avoiding chasing dividend stocks for their pay-offs, among the most important steps you can take with your retirement income is to adopt a portfolio-wide approach to money management, instead of viewing your income and principal as two isolated islands of assets. We’ll explore this subject in a future post.