From the March 2006 issue of Boomer Market Advisor • Subscribe!

March 1, 2006

Boomers and bonds

As of January 1, the first wave of boomers turned 60. Additionally, about four million turn 50 each year -- entering a key pre-retirement phase generally considered a financial turning point. Shorter investment horizons call for, among other things, a conservative rebalancing of investment portfolios.

Because bonds represent a more stable and predictable income stream than equities, they should generally represent a larger portion of a client's asset allocation. For graying boomers, it makes sense to shift a portion of the portfolio to medium and low-risk instruments, while still maintaining a healthy, but smaller, percentage in higher-risk vehicles.

But bonds traditionally fall into the sensible, but boring, category on the menu of investment choices -- attributes not normally associated with the boomer demographic.

"Boomers are [beginning to] shy away from so-called riskier investments," says Rocco Carriero, an advisor with Ameriprise Financial in Southampton, N.Y. "Capital preservation and income generation start to become logical goals as people age. Some boomers have seen the value of their stock investments do nicely or they have a lot of cash in money markets. In either case, it can make sense to move a portion of the capital to fixed instruments."

It's important to educate boomers on the particulars of bond investing, especially to those heavily focused on equities and real estate. Bond prices and interest rates are inversely related, and rising rates can devastate a bondholder's portfolio. The inverted pyramid dictates that when interest rates fall, bond prices rise -- and vice versa. The longer a particular bond's maturity, the more sensitive it is to interest rate movements. The bond's price change, combined with the income it pays, determines its total return.

"For boomers who tend to like investments that have higher risk and growth potential, bonds can be a nice conservative piece to a well-rounded portfolio," says Tracy Brown, an advisor based in Latham, N.Y.

The time is right
When many boomers start second careers or launch businesses after they leave their primary career, in most cases, their years of earning a steady salary are limited. Boomer advisors interested in adding financial stability to their clients' lives should point to the value of capital preservation and income generation. And while many believe bonds to be virtually risk free, there are several factors that advisors should point out. Interest rate movement, inflation, lack of liquidity, repayment and in some cases, political risk (most frequently associated with emerging markets) can cause confusion and stress.

"A common misconception is that all bonds are safe," Brown notes. "With bonds that provide higher returns come higher risks.In a rising interest rate market, it can be difficult to unload bonds that are paying lower rates."

In a rising interest-rate environment an over-weighting in more conservative bonds might mean an investor will not keep pace with inflation. A lack of liquidity can compound this problem and make a case for more liquid bond funds.

"Bonds represent distinct investment classes," says Steve Semryck, president of Hauppauge, N.Y.-based Semryck Financial. "There's always a need for bonds to limit investing risk. When you show an asset allocation illustration, the need to be in different investment classes becomes apparent. Bonds are a distinct class that can also maximize your clients' interest-earning potential. The key is asset allocation."

Semryck frequently steers boomer clients to municipal bond funds and global high yield funds to provide diversity as well as a greater rate of return. Bond funds invest in securities with different coupon payments. The income received is then distributed to mutual fund shareholders and the amount can vary each month. While market conditions impact a bond fund's value, investors depend on the diversification provided by the fund manager to lessen risk from individual bond issuers. However, depending on when shares are sold, a capital gain or loss may be taken.

"Bonds are not designed to perform in the same manner as equities or real estate, but rather to complement them," Brown says. "Since bonds tend to do better when the market doesn't, it makes sense to include them [in a portfolio] so that no matter what the market does there's a portion of the portfolio that's growing."

Repayment or credit risk can also occur. The most frequent is default in repayment on the part of the issuer. The reverse can also be true. Clients are repaid before they wish or expect to be. Credit risk occurs when a bond is purchased because the obligation is only as strong as the issuer's ability to repay. Major governments, as well as highly regarded municipalities and corporations are reliable issuers. Lower-rated bonds pay a higher amount of interest but investors will take on a corresponding higher amount of risk.

So, what percentage of bonds should a boomer portfolio ultimately hold?

"A good rule of thumb is from 10 percent to 30 percent," Brown says. "As clients' needs change, say as they approach retirement, this number would probably increase to preserve their assets."

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