An Insidious Threat to Your Income

Original post

There is an insidious threat to the security of our income, and it has to be unwound now.

I call it the “stealth threat to retirees,” and it all comes down to time. Let me explain…

As we age, we have to reduce the risk in our portfolios. Scaling back our risk exposure is essential because we have less time to recover from a major correction as we get older.

Anyone who survived the sell-offs of 2008 and 2009 knows what I’m talking about.

Most people reduce their risk with bonds because bonds offer everything an older person’s portfolio needs…

  1. Predictability. Before you invest one cent in any bond, you need to know the minimum amount of return you can expect. It’s called the yield to maturity.
  2. Reliability. The long-term success ratio for bonds is anywhere from 99.9% for investment-grade tax-frees to 94% for high-yield bonds, the riskiest of all bonds.
  3. Dependability. The interest a bond pays cannot be suspended, reduced or eliminated.
  4. Stability. The market value of quality bonds fluctuates significantly less than stocks.

But if you have been buying bonds or bond funds based only on yield just to earn a livable return during the years of low interest rates, most of the pluses I just listed are out the window.

And most bond and bond fund owners are oblivious to the threat of long maturities.

The longer the maturity of a bond, the greater its price will drop when interest rates move up. And Fed Chairman Powell has stated quite clearly that he intends to continue raising rates.

During the years of zero percent interest rates, the market was flooded with 20-, 30- and even 100-year maturity bonds. And income buyers, trying to pay their bills, were snatching these bonds up as quickly as they were issued.

It was the only place to get any yield. But times have changed, and you must adjust on the fly. Get out of those long-maturity bonds and bond funds, or get ready for a nasty surprise.

Unless you have the discipline to hold your long bonds no matter what happens to them, shorter-maturity bonds (an average maturity of five years) are your best alternative.

They also are now paying a minimum of 5% to as much as 9% per year, and some of the speculative type are paying double- and triple-digit rates. There’s a lot of safe money to be made without the downside risk of increasing interest rates.

And shorter-maturity bonds are the only bonds – Treasury, municipal or corporate – that you can safely hold in an increasing interest rate environment. (And they are rising… They’re up 1.125% since Trump took office.)

They are the only kind to own because they have a lower duration. Remember, duration dictates how much a bond will drop in value when rates go up.

A bond with a duration of five will drop 5% in value with a one-point increase in rates. A duration of 10 will drop 10% and so on.

Durations for long-maturity bonds are some of the highest in the bond universe. You cannot own them in the new, higher-rate environment we are entering.

Shorter maturities also make money available to reinvest at the new higher rates. Their shorter holding times return your principal and allow you to put your money back to work sooner.

I have been pounding the table about this shift in rates and the threat it poses to the most secure part of our portfolios for years. That threat has finally arrived.

Bonds are still the safe harbor we gray hairs need for our money… Make sure you own the ones that will outperform going forward.

Good investing,

Steve