Sunday, October 14

Week 67 - Bonds and Bond Funds

Situation: To quote from a NY Times editorial on 9/16/12 ("The Road to Retirement"): "More saving is clearly needed, along with ways to protect retirement savings from devastating downturns. The question is how." That quote serves as both the Central Thought for the ITR website and introduces our blog this week. 

Protecting retirement savings from an economic downturn amounts to setting up fixed income hedges against that possibility. One way to do that is to invest in hybrid stocks that are actually bonds in disguise (i.e., regulated utilities). Another way is to invest in a bond mutual fund wherein the manager can choose between a variety of offerings, including foreign bonds, e.g. T. Rowe Price New Income Fund (PRCIX). And for a third suggestion, we continue to recommend that our readers regularly add inflation-protected US Savings Bonds (ISBs) to their Rainy Day Funds (see Week 15).

By investing regularly in stocks, you'll capture part of the profits made in a growing economy but at what cost? The cost is the possibility of losing all of the dollars you've carefully invested in a company's stock should that company declare bankruptcy. And, in the event of a market collapse, all of your stocks will fall in value until the market recovers. If you happen to retire when the market is collapsing, you'll be loathe to sell at a loss but could find you have no choice. 

Bond investing captures an unchanging stream of income from money you've rented out, money that will be returned to you on a date certain. Should the "rentee" declare bankruptcy in the meantime, you'll still receive your share of the remaining assets. In short, stock investing requires you to accept uncertainty; bond investing doesn't. Inflation, however, decreases the purchasing power of any interest income you've earned from bonds and bond funds. This is not as important as you might fear if you reinvest your interest income and regularly add to your portfolio of bonds and bond funds.

Using bonds to buffer a temporary stock market loss is a simple way to maintain what you've obtained. All of us now know the value of doing so: After 5 years, the stock market is still short of its October 2007 high while bond investors have enjoyed annualized total returns of 7% (PRCIX).

A note of importance: The US Treasury has increased the money supply since 2007 to lower federal borrowing costs and make US exports cheaper on foreign markets. The term to describe this is “financial repression.” To accomplish this, the Federal Reserve expands its balance sheet through multi-trillion dollar purchases of US government bonds on the open market. This has driven the price of 10-yr Treasury Notes so high that interest on the Notes has fallen to the current inflation rate. That means there is now a risk of loss to investors in these Notes should inflation pick up: 10-yr Treasuries may no longer be the “zero risk” investment they once were. 

Bottom Line: Stocks in general are 4-5 times as risky as bonds (Riskmetrics). That riskiness can be dialed back if you select stocks that have been issued by companies with low debt and a history of growing dividends. Nonetheless, you'll still need to keep at least half your retirement money in bonds and utility stocks to buffer market downturns.

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