It is not news to anyone that interest rates are low, and have been for quite some time. Historically retirees were able to cover daily living expenses with fixed income portfolios as a key component of their overall retirement plan.
Times are very different now, and investors and clients are having a tough time searching for yields for income using highly rated bonds or bond portfolios. Bank CD rates and other fixed interest paying investments are at all-time lows. I’ve heard of a number of different solutions that advisors are deploying; one of the most concerning to me was hearing that advisors were extending duration on bond portfolios to chase yield.
I’m here to ask — why?
The Risks of Chasing the Yield
Extending duration on a bond portfolio needlessly increases risk to your client by introducing interest rate risk into the portfolio, and can vary in return significantly with interest rate fluctuations. Interest rate risk is the potential for investment losses that result from a change in interest rates.
What Your Peers Are Reading
By extending duration, the client has additional exposure simply because the duration or maturity of the bond is extended. If interest rates increase, there is a risk that the client will receive less than the principal invested, because that bond is paying a lower rate than what the market is paying. There are a number of alternatives that advisors can deploy that do not increase the risk to the client and provide steady, safe, and secure retirement income while preserving the client’s principal.
(Related: 6 Rolls of Toilet Paper v. Life Insurance)
As a baseline, let’s take a look at one of the most popular bond indexes out there: Bloomberg Barclays US Aggregate Bond Total Return Index. The 10-year trailing total return for the index is 3.82%, and the index is made up of investment grade bonds. The 10-year trailing return is a pre-tax return; after federal and state income taxes are assessed, the client’s net after tax return will be lower.
One viable solution to consider as a bond alternative is a fixed deferred annuity. Annuities are triple compounding solutions: Clients earn interest on principal, interest on the interest, and interest on the tax savings.