Planning for retirement can be fraught with risk when income needs are ignored. Anyone planning a full stop on current employment to substitute income from portfolios and Social Security needs to consider investment allocation when making this transition.
During an accumulation phase of building resources for retirement, many investors overweight on stocks and stock funds, rather than bonds, looking for growth rather than current income. Investors transitioning into retirement need to take a hard look at income, as well as capital preservation, that is, preserving hard earned capital that may not easily be replaced.
While there are many types of bonds, corporate bonds and securities particularly should be considered to help provide predictable income for financing retirement. Investment grade corporate bonds typically have less standard deviation, that is, less variance in their valuations during a holding period, than do stocks. They typically pay interest twice yearly at a stated coupon rate. If longer maturities, 15 years or more, are selected, coupons for investment grade bonds can exceed 6%. Investment grade bonds are usually considered to be rated in the A or triple B range, not lower.
Bonds are rated for credit quality by ratings agencies, including Standard & Poors, Moodys, and Fitch. Advisors work with their clients to help them understand what these ratings mean in judging how the bonds may perform over time.
While bond funds and ETFs are another investment option, the dividends paid from these instruments may not approach those paid by actual bonds. A careful review of the choices available is prudent, when planning for the annual income necessary to finance household budgets.
Preferred stocks issued by corporations such as utilities and banks may be another option. Like bonds, preferred stocks are rated for credit quality as fixed income investments. They often pay four times yearly instead of just twice yearly, and yields – or annual dividends – are typically higher than interest paid by corporate bonds. While debt instruments, preferred stocks carry somewhat more risk than do investment grade bonds. Dividends may not be guaranteed, though most companies issuing preferred stocks are loathe to skipping payments. Missed dividend payments can change the issuer’s credit rating.
When deciding whether corporate bonds belong in your portfolio, consider the implications of lower standard deviation. Morningstar, the independent rating company, has estimated the standard deviation for the S&P 500 index on a three-year basis to be plus or minus 16.92%, and on a 10-year basis to be plus or minus 15.22%. This means that roughly 2/3 of the time, if the annual mean return is 12%, the value of the index can range between 28.92% to negative 4.92%. In a bad year, when market results may vary by two standard deviations or more, these results can change even more.
Meanwhile, bonds exhibit more sedate behavior. For the corporate bond ETF LQD, which tracks intermediate duration US corporate bonds, Morningstar found standard deviation on a three-year basis to be plus or minus 11.56%. So, if a mean return is 4.5% annually for corporate bonds, the actual market value can vary so that values range from 16% to negative 7 percent 2/3 of the time. That is, in normal markets with variance limited to one standard deviation of historic returns, values would remain within this range. Shorter duration ETFs currently have less standard deviation. For instance, the Invesco 2025 High Yield ETF BSJP, tracking B range or lower rated corporate bonds, has a standard deviation of plus or minus 5% on a three year basis, according to Morningstar.com.
Anyone nearing retirement needs to consider their total risk profile. What is important for you? If you consider yourself to be a moderate risk investor, then you would allocate at least 20% to 30% of your holdings to cash and fixed income. If you don’t you risk outsize swings in the valuation of your portfolio when the market conditions change, becoming more volatile.
Buying and selling actual bonds involves choosing an appropriate price to face value spread. Prices change with interest rates and can involve a premium to actual face value of the bond, depending on interest rates. A skilled broker can ensure that the buyer doesn’t overpay for the cash stream value of the underlying security.
