Are Bonds Really That Safe?

Income markets are “inverted,” and the historically safe bond market is better used as a risk management tool than an actual source of income, according to Charlie Farrell, CEO of Denver-based Northstar Investment Advisors.

“Historically, and I’ve felt this way as well, bond yields and bond income was a safe way to access a healthy amount of retirement income once you needed to start taking distributions,” he told ThinkAdvisor on Thursday. “Today, things really are inverted in the income markets. If you look at what we went through in the financial crisis, people know that stock dividends were cut — let’s look at the S&P 500 in general — and they were: A lot of financial firms cut dividends, some even eliminated them.”

However, Farrell continued, dividend income declined by about 21% since its peak in 2007 prior to the crisis. Now, not only have they recovered, they’re 23% to 24% higher than they were at the peak, while bond yields are around 50% of what they once were, Farrell said.

Farrell used 10-year Treasuries as an example. Say you have $1 million in securities that generates about $45,000 or $50,000 per year. “Now that million dollars of securities — you still have your money, but it might only be generating $25,000 or $28,000 a year. You’ve had a significant cut in your bond income, even though there were no defaults and you didn’t make any bad investment decisions.”

This is certainly a long-term situation, too, Farrell said. “Going forward it’s even more difficult because now we’re looking at bond yields, let’s say 2.5% to 2.75%. You’ve got stock dividends for a lot of high-quality companies that are equal to or higher than that right now, and dividends are tending to grow anywhere between 5% to 7% a year. If you look out over the next 10 to 15 years, which one of these income streams is likely to be riskier?”

The big risk with bonds, according to Farrell, is that “decisions made by the Fed that are totally out of our control have more than cut the income on the bond side in half. Yeah, we think of that as safe, but there’s really nothing you can do about it.”

Furthermore, he said, the drop in income from dividends was less than the drop from falling interest rates.

“Short-term interest rates went from 3% to zero,” he said. “You have money sitting in a short-term fund, you might have been getting $30,000 per million — now you’re getting zero. Bond income is not really in terms of safety if you think, ‘Yes, it’s guaranteed,’ but that’s not the only safety you need to think about.”