Earlier this month, my column covered bond basics – how they work and their proper purpose in a blended growth portfolio. But many see a 100% (or very heavy) bond portfolio as a set-it-and-forget-it safe income generator.
Considering various risks shows why bonds alone rarely are best for retirement cash flow.
1. Interest rate risk.
Bond prices and interest rates move oppositely. When interest rates rise, bond prices fall. Rates will probably increase little in 2019, but when they do, selling before maturity (to meet an expense, perhaps) locks in losses.
2. Credit risk
Otherwise called default risk – the potential that a bond issuer reneges on the contract. When the issuer can’t make interest or principal payments, they default. Depending where you sit in a bankruptcy pecking order, you may not get your money back. When Greece defaulted in 2012, bondholders suffered huge losses. Higher credit risk bonds carry high-interest rates – alluring – but that simply balances the higher likelihood of loss.
3. Liquidity risk
With individual bonds rather than a bond fund, you can hit trouble when it’s selling time. Many bonds – particularly corporate and municipal issues – don’t trade much. That can make them tricky to price and find buyers for. Most bonds aren’t like stocks, which trade daily on public exchanges. Selling can be more slippery than a politician’s pretty promises. You can’t sell in a flash near prices found online. Selling a “thinly” traded bond with few buyers can leave you forced to sell at steep discounts – particularly if there are no buyers and you need the proceeds fast for unexpected reasons.
4. Reinvestment risk
Owning high-interest bonds from low-risk issuers – and planning to hold them until they mature – may seem fool-proof. Yet even here, risks lurk. Many corporate bonds are “callable” – meaning the issuer can redeem them at will. Companies often do this when interest rates fall. Why keep paying the higher rate when they can call the bond at below market prices and float a cheaper new one? Good for them. Bad for you.
Even if your bond isn’t called, trouble can loom when it matures and you must replace that income stream. What if you can’t find something with a high enough yield? A 30-year U.S. Treasury bond from 30 years ago paid over 8% a year. Good luck finding that with low default risk now! America’s current 30-year yield is below 3%. You can’t even get near to 8% in Greece! Its 25-year debt pays just 4.3%. You’d need a 30-year Mexican or Brazilian bond, skyrocketing credit risk.
5. Inflation risk
Few bonds have inflation-linked interest rates. Normally, interest is the same each year. When the bond matures, you get the exact face value back. Over time, even low inflation erodes the interest income’s purchasing power. Ditto for your principal. With a 10-year bond maturing now, the $1,000 you receive buys far less today than it did when issued in 2009. To maintain purchase power, your money must grow.
Don’t get me wrong. I like bonds. Unlike many investments, they are transparent, with definable risks, and respond exactly proportionally to those risks – unlike many non-transparent and complexly defined investments, say, many annuities (per my April 14 column).
So, they are a good tool but like any tool must be used correctly with eyes wide open on their risks.
Usually, that is done best as part of a bigger blended portfolio aimed at growth where the bonds’ role is, above all, to provide relative stability by dampening volatility.
Ken Fisher is founder and executive chairman of Fisher Investments, author of 11 books, four of which were New York Times bestsellers, and is No. 200 on the Forbes 400 list of richest Americans. Follow him on Twitter: @KennethLFisher
The views and opinions expressed in this column are the author’s and do not necessarily reflect those of USA TODAY.
This article originally appeared on USA TODAY: Bonds aren't a set-it-and-forget-it investment. Here's what you need to know.