Why Bonds Still Make Sense in a Retiree's Portfolio

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Bonds are in the doghouse.

The recent rise in interest rates has many investors questioning whether bonds still have a place in their investment portfolio. It’s a legitimate question. Interest rates and bond prices move in opposite directions. When interest rates go up, bond prices fall. This reality has even the most cautious investors wondering if it's time to adios their bonds.

Basics of Bonds

Bonds are simply IOUs issued by companies or governments. When you buy a 5-year bond for $10,000, the seller is using the $10,000 for that specific term, while at the same time paying you an annual interest rate. At the end of the term, a.k.a., the bond’s maturity, you get your $10,000 back. Over the whole term, you’ve collected $500/year, (5 percent on $10,000), and had your original principal returned. Of course, if the entity that issued the bond goes broke or gets overthrown by revolutionaries, you lose your investment.

How often do bonds default? It depends on the kind of bond. US government bonds are the gold standard of credit. According to Carmen Reinhart from Harvard’s Kennedy School, the US government has not defaulted since the late 1700s. This makes US debt “risk-free.” However, plenty of other governments have defaulted on bonds, including Greece and Argentina. 

Corporate bonds are also considered to have a low probability of default, with the average default rate of less than ½ of 1 percent over the past 50 years. High-yield or junk bonds paint a slightly different picture, with an average 20-year default rate of 3.9 percent.

Interest Rates are Hard to Predict

At the start of 2014, 67 out of 67 economists cited in a Bloomberg News report predicted a significant rise in US interest rates as measured by the US 10-Year Treasury Bond. By the end of that year, all 67 of those economists were wrong. In January 2014, the 10YT hit 3 percent. At year’s end, it was closer to 2 percent. Oops.

Similar predictions have been widespread (and equally incorrect) since 2010. So, what if you stayed out of the bond market over the past seven years thinking rates would rise? In cash, you would have earned about 0.7 percent (0.1 percent/year X 7 years). Compare that to the US core aggregate bond index ETF (AGG), which has a total return of 27 percent or 3.5 percent per year.

Don’t get me wrong. I’m not saying rates won’t go up from their current levels — the 10-year Treasury is currently hovering around 2.5 percent. I’m just saying that predicting interest rate trends and the fate of the bond market is tough even for the experts — as tough as predicting the highs and lows of the stock market.

Not all Bonds Are The Same

Different bonds react differently to rising interest rates. A bond’s time-to-maturity, or duration, helps predict how its price will be impacted by a change in interest rates. Very long-term bonds (30-year US Treasuries) will fall 17.7 percent when interest rates rise 1 percent while floating rate bonds stay virtually flat. Keep in mind that this doesn’t account for the income you receive from the bond in a given year. So, in the case of floating rate bonds, convertible bonds, and US high yield bonds, the average income (interest) paid will often lead these categories to a positive total return, even in the face of rising rates.