4 Tips About Bond Investment for New Retirees
When you finally retire, it’s important that you have built a strong foundation of investments around yourself or you’ll soon be back to work just to stay afloat.
While there are many ways you could plan for your retirement, investing in bonds may be one of the best.
Still, before you go rushing into bond investment, make sure you consider these four tips.
Diversify Your Bond Investment Strategy
A lot of people make a very careless mistake when they begin with bond investment. It’s based on the idea that bonds are one of the safest investments you can make.
That may be true, but that doesn’t mean you still don’t want to diversify your portfolio. This is why it’s such an unfortunate mistake to make, because, in the end, most people understand that you always want to diversify.
To that end, your bond investment portfolio should include these three types:
- High-grade corporate bonds
- Treasury bonds
- Municipal bonds
That last one is only recommended to those of you who are in high tax brackets because interest on those is tax-free.
Another way to look at diversification is in the quality of the bonds you purchase. Now, if you’ve just retired, you probably want to stick to high-quality bonds, but for some of you, this may still be a relevant topic to cover.
In short, low-quality bonds are going to produce higher spreads. As rates go up, credit spreads usually compress.
In some spectrums, that compression will actually overcompensate for a rate increase and thereby result in a lower overall yield and higher total price.
Essentially, the compensatory action of spreads buffers against the impact of rate hikes.
Again, this will be a very personal decision, but it’s smart to at least know your options and understand that diversification is a requirement.
Understand the Risks
While we’re on the topic of mitigating risks related to bond investment, let’s take a look at two types you need to know about:
- Interest Rate Risk
- Credit Risk
The first is present amongst every type of bond. This risk stems from the relationship between bond prices and rate fluctuations, which is an extremely sensitive one.
When the market expects interest rates to go up, bond prices are going to fall. Those bonds with a longer duration are going to be more sensitive to these rate changes.
The more sensitive they are, the more their price will fall during an expected rise in interest rates.
Then there is a credit risk. This simply refers to the potential for any issuer to default by not paying bondholders what they’re owed or at least returning them the principle.
Those issuers with poor credit ratings also pay higher spreads because they are at a greater risk of defaulting.
Here is another way in which bond investment is quite similar to trading stocks. Once again, you must decide how much risk to take on.
If you have the funds, and time to recover if necessary or you have a reliable source of income in your retirement, it might be worth putting some money behind riskier bonds in order to enjoy the potential for superior returns.
Use a Continuous Rolling Horizon
One way retirees can set themselves up for success is by using what is known as a continuous rolling horizon. In a moment, we’ll talk about using a dedicated portfolio.
Right now, though, for the sake of describing a continuous rolling horizon approach, all you need to know is that it’s a form of bond investment where the other half of the portfolio goes into equities.
Let’s look at an example of a woman who applies this approach.
During the first 10 years, her dedicated portfolio of bonds will take care of her expenses (assuming an adjustment for inflation). Her equity investments will grow as well.
Now, after 10 years, her bonds have dried up, but her portfolio of equities may double during that time or even more.
When that happens, she resets the portfolio of individual bonds. Adjusting for inflation, this new bond investment will cost a bit more. She’ll use the returns from her equities to cover it.
After another decade, she will again empty her dedicated portfolio of individual bonds. At this time, though, there should be enough money for a longer portfolio stint off, say, 13 years.
This could continue indefinitely, but what happens during a down market? What if the 10-year period ends when the market is in turmoil? She would have to sell off her equities and take a loss.
With continuous rolling horizon, this is avoided because the reset is done every single year. All she would have to do is sell her equities to pay for more bonds. By doing so, the impact of selling during a down time in the market is dissipated.
Take a Dedicated Portfolio Approach
Finally, let’s talk about dedicated portfolio approach, which we just touched on briefly.
This method was invented by Dr. Stephen J. Huxley and his partner, Brent Burns. Both were researchers at the University of San Francisco. It was during their time there that they came up with the idea for “Asset Dedication: How to Grow Wealthy with the Next Generation of Asset Allocation.”
The approach divides the portfolio into three categories of assets:
These all form one portfolio which can be aimed at different, unique goals. Once the investor has their goals, a more precise allocation proportion can be created as opposed to the typical “one-size-fits-all” version many retirees succumb to.
The primary purpose of dedicated portfolio approach is the minimization of risk, something every retiree wants. It matches future cash flows with liabilities. Apparently, to keep ahead of these liabilities, bond investment plays a significant role.
Bond investment may come with a number of benefits, but that doesn’t mean it’s the sort of thing you should rush into.