Understanding Bonds and Their Role in Retirement Investing

Think bonds are just boring, safe investments? After the historic drop in 2022, many retirees learned the hard way that fixed income comes with teeth. Let's look past the generic advice and break down exactly how individual bonds, ETFs, and laddering strategies actually function when you are living off your savings.

👉 [Listen to the Full Podcast Episode Here] 

Today, we are diving deep into the world of fixed income. We will unpack exactly how bonds work, look at the core differences between individual bonds and bond funds, and map out the specific strategies retirees should consider to protect their lifestyle.

What Exactly is a Bond?

Think of a bond as a loan you make to a corporation or a government entity. When you invest in a bond, you are acting as the lender. In exchange for your upfront cash, the issuer promises to pay you regular interest payments for a specific period of time, and then return your original principal when the bond matures.

Bonds are initially issued at Par Value, which is typically $1,000. During the life of the bond, its actual market price will fluctuate above or below that $1,000 mark based on shifting interest rates and the creditworthiness of the issuer. If you hold an individual bond all the way to its maturity date, and the entity stays solvent, you receive your full $1,000 par value back plus the final interest.

While bonds are historically far more stable than stocks in the short term, they generally deliver lower long-term returns than equities.

A Practical Example of Bond Pricing

Imagine you purchase a one-year government bond below par value for $990. The bond features a 4% coupon rate. When the year concludes, the government pays you the $1,000 par value plus $40 in interest. You walk away with $1,040 total. That represents your $990 investment, a $10 market gain, and $40 in interest, resulting in a Yield to Maturity of approximately 5.04%.

The Different Flavors of Fixed Income

Bonds come in several distinct varieties, each carrying its own unique risk profile.

• U.S. Treasuries: Backed by the full faith and credit of the U.S. government, these are widely considered the safest debt instruments available.

• Agency Bonds: Issued by government-run or government-sponsored agencies. Their credit ratings are exceptionally high, sitting just a notch below Treasuries.

• Municipal Bonds: Issued by local and state governments to fund public projects like schools or roads. They offer valuable tax advantages. General Obligation (GO) bonds are backed by the municipality's taxing power and are usually safer than Revenue bonds, which rely strictly on the income generated by a specific project.

• Corporate Bonds: Issued by businesses to fund expansions. These exist on a spectrum. Investment-grade corporate bonds are backed by large companies with fortress balance sheets. High-yield bonds (junk bonds) are issued by smaller or highly leveraged companies. They pay higher interest but carry a much greater risk of default.

Managing Default Risk

If a company goes bankrupt, bondholders are prioritized and get paid before stockholders. However, defaults still happen. Between 2005 and 2022, high-yield corporate bonds averaged a modest 1.5% default rate. But during the 2008 financial crisis, that default rate spiked to 5.3%, and it hit 4% during the pandemic panic.

Because of this volatility, individual bond investors should stick to U.S. government debt, municipal bonds, and investment-grade corporate bonds. If you want exposure to high-yield junk bonds, it is safer to access them through a highly diversified mutual fund or ETF rather than buying them individually.

Individual Bonds vs. Bond Funds vs. Bond ETFs

When building a fixed-income portfolio, you have to decide how you want to own these assets. Each path has distinct structural trade-offs.

Bond Mutual Funds

You pool your money with other investors to buy hundreds of different bonds. This gives you instant diversification. However, you must keep an eye on internal management fees. Additionally, during times of extreme market panic, fund managers may be forced to sell underlying bonds at a loss to generate cash for exiting investors, leaving the remaining shareholders to absorb those costs.

Bond ETFs

These offer a low-cost, passive index strategy. They trade like stocks on an open exchange. During market disruptions, bond ETFs can occasionally trade for less than their Net Asset Value (NAV), but these pricing mismatches typically correct themselves once liquidity returns to the market.

Individual Bonds & Bond Ladders

Buying individual bonds gives you a guaranteed return of principal at maturity, assuming no default. The most effective way to deploy them is through a bond ladder. By staggering your maturity dates (e.g., having bonds mature every year or every quarter), you avoid getting locked into a single interest rate and create a steady, predictable stream of cash flow.

Why We Prefer Passive Bond ETFs

While active bond managers tend to perform better historically than active stock managers, consistently picking a winning active fund over the long haul remains highly unlikely.

Data from Morningstar shows that at the end of 2022, only about one-third of actively managed bond funds successfully beat their passive benchmarks over a 10-year period. When you extend that timeline out to 15 or 20 years, the success rate for active managers drops even further.

For the majority of retirement portfolios, utilizing low-cost, index-tracking Bond ETFs provides the cleanest execution. For larger accounts with highly specific cash-flow needs, a customized individual bond ladder can be layered in.

The Reality Lesson of 2022

We cannot talk about bonds without addressing the elephant in the room. In 2022, rapidly rising interest rates caused historic, double-digit drops across the bond market.

As noted in a CNBC report by journalist Greg Iacurci, Santa Clara University professor Edward McQuarrie conducted an analysis of historical investment data and concluded:

"Even if you go back 250 years, you can’t find a worse year than 2022 for the U.S. bond market."

While 2022 was a painful anomaly, the silver lining is that those older, low-yielding bonds have washed through the system. The bond funds and ETFs available today are paying significantly higher yield percentages, setting up a much stronger forward-looking environment for savers.

Tailoring Your Bonds to Your Retirement Strategy

How you structure your bonds depends entirely on what you need them to accomplish.

If you maintain an equity-heavy portfolio (50% or more in stocks), your bonds are there to act as a shock absorber. In this scenario, leaning heavily toward Government Bonds is highly effective. Government debt has the lowest correlation to the stock market, meaning that during major equity sell-offs, government bonds frequently rise in value as investors look for a safe haven.

This stability is vital for retirees taking regular distributions. In a notable retirement study, Dr. Wade Pfau modified the traditional 4% rule framework. By replacing corporate bonds with Intermediate Government Bonds, the portfolio sustainability success rate climbed to a perfect 100%, outperforming the original Trinity Study's 95% success rate which relied on investment-grade corporate debt.

The Ultimate Conservative Setup

If you are highly risk-averse and your portfolio consists primarily of fixed income, you need broader diversification to generate adequate yield. Your allocation should feature a thoughtful blend of government debt, investment-grade corporate bonds, global bond funds, and a small sliver of high-yield exposure.

To completely insulate yourself from short-term market panics like 2022, consider keeping a few years' worth of core lifestyle expenses tucked safely inside ultra-short-term government bonds, certificates of deposit (CDs), or high-quality money market funds.

Summary

Bonds are not a single, monolithic asset class. Whether you deploy a staggered bond ladder for absolute principal protection or utilize low-cost government bond ETFs for equity diversification, the goal remains the same: align your fixed-income architecture with your personal psychology and your true cash-flow timeline.

Next Steps for Your Retirement

Ready to take the next step? I’d love to help you build a retirement plan, investment plan, and tax strategy.

Visit us at CapitalWealthGroupSC.com to see how we work with the 50-to-60 crowd. If you’re ready to dive into your numbers, you can schedule a 30-minute Introductory Call right here.

Let’s make sure you're on the right track for the retirement you want.

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Full Podcast Transcript

Understanding Bonds and Their Role in Retirement Investing

So, let's get started!

Today we are talking about bonds! How bonds work, the different types of bonds, bond funds versus individual bonds, and what types of bonds retirees should consider owning in retirement. 

Segment 1: Unpacking Bonds and Their Types 

Think of a bond like a loan you make to a company or government. You give a Company or govt money and they promise to pay you interest for a specific amount of time. Here’s another way to look at it. When you invest in a bond, you're basically the lender. You're giving them money, and in return, they're saying, "Hey, we promise to give you your original money back, that's your 'principal,' and we'll also pay you interest on a regular basis for a specific amount time."

Bonds are initially issued at Par Value. The par value, also called face value, is usually $1,000. However, the market price of a bond might be higher or lower than the par value during the life of the bond. It all depends on things like interest rates and how trustworthy the issuer is. Assuming the entity is still viable, when the bond matures you will be paid back your original investment at Par Value, $1,000 plus the interest earned. 

Bonds tend to be on the stable side in the short run, unlike stocks that can be volatile especially over shorter periods. However, over the long run, at least historically speaking, US bonds usually don't perform as well as US stocks do. 

Here’s an example where you buy a bond below Par Value: You buy Government Bond for $990. It comes with a 4% coupon and a one-year term. When that year is up, they give you $1,000 plus the $40 in interest. So, you walk away with $1,040 – your original investment of $990, plus $10 in gains and $40 in interest. Your Yield to Maturity is approximately 5.04%. 

 Bonds come in various types and maturities – You've got Government bonds like Treasuries and Agency bonds. People tend to think of them as safe bets because, Treasuries are backed by the US Govt and Agency bonds are issued by government agencies and their credit ratings are almost as good as Treasuries.  Then you have Municipal bonds which are issued by local governments and can give you some nice tax benefits. There are two types of Municipal bonds, you have General Obligation bonds, and you have Revenue bonds.  GO bonds are often safer than revenue bonds. Next you have corporate bonds that often play a balancing act between safety and yield. Within the Corporate bond category, you have investment grade, which are usually backed by larger companies with strong balance sheets and then you have below investment grade also called High yield or junk bonds. They are often smaller companies or companies with more leveraged balance sheets.   Of course, all of these bonds have different maturity dates ranging from less than a year to 30 years in the case of Treasuries.  When it comes to the risk of default the lower the credit rating and the longer the bond has to maturity the more default risk you have, especially with corporate bonds.

Each type has its own level of risk and potential rewards. Bonds have limited upside but also are often safer than stocks because as long as the entity doesn’t go under you will get back your initial investment plus the interest and sometimes a limited gain if bought below par. In addition, if the entity were to go under, bond holders are first in line to get paid while stockholders are last in line. 

However, this doesn’t mean you’re guaranteed to get your investment back and may end up losing it all. This is why, if you decide to buy individual bonds, I recommend focusing on US government bonds, municipal bonds, and investment grade corporate bonds. Even though US High Yield corporate bonds have maintained an average default rate of only 1.5% over the past 15 years from 2005 to 2022, during economic downturns and market stresses like 2008-2009. High Yield defaults jumped to 5.3%. Also, during Covid defaults reached 4%. If you are interested in the high yield bond category, it may be better to consider investing in a high yield mutual fund or ETF.

 So, who issues these bonds and why? Like I said earlier, governments and corporations often issue Bonds. Governments often issue bonds to raise funds for daily operations and projects like roads, buildings, schools and so on. Central banks also use bonds to regulate a country’s money supply, but that’s a whole other conversation. Corporations issue bonds to fund expansions and other business activities.  

So, what affects a bond's price? It's a mix of factors including interest rates, credit ratings and overall market conditions. When interest rates rise existing bonds with lower rates become less attractive causing their prices to drop.  

Segment 2: Bonds, Bond Funds and Bond ETFs – Which Route to Take?

So, when it comes to bond investing, there's a lot to consider. One such decision is between Bond funds, Bond ETFs and individual bonds. They each have their own set of pros and cons. Let's break it down.

With bond funds, you're essentially pooling money with other investors to create a diversified portfolio of bonds. This can be a good thing because you will usually own 100’s of bonds and it spreads out the risk. Instead of putting all your eggs in a handful of bonds, you've got a bunch of them. But watch out for fees – some funds charge less, while others can be quite expensive.

On the other hand, individual bonds can offer some peace of mind. If you hold them until they mature, you will get your initial investment back, assuming the issuer doesn't go under. But unlike buying individual stocks, individual bonds don’t trade on an exchange and are not as easy to buy and bond research can be a lot harder as well. 

Here’s one thing with bond funds that some dislike – during market stresses fund managers might have to sell bonds at a loss or below NAV to cash out investors who sell their shares. The shareholders who stay are the ones to absorb that cost.  Bond ETFs have their own issues too. During market stresses, Bond ETF’s may sell off more than their NAV, but if you don’t sell, it should correct itself when markets calm down and become more liquid.  

In general, if you prefer actively managed bond funds, then bond mutual funds may be the way to go. If you prefer low-cost passive index bond investing, then Bond ETFs may be the way to go. There are some actively managed bond ETFs and may be worth looking into as well. 

Let’s look at what happened in 2022. Many US Bonds, US bond funds and US bond ETFs took a major hit. Interest rates shot up fast and by a large amount causing many bonds related investments to drop in price often by double digits. However, 2022 was not a normal year for US bond investing. In fact, according to an analysis by Edward McQuarrie, a professor at Santa Clara University who studies historical investment returns. Said, “Even if you go back 250 years, you can’t find a worse year than 2022 for the US bond market,” This was from a CNBC article by: Greg Iacurci. And here's the silver lining – if you hang in there, those funds that were paying low interest are now paying much higher interest, and you'll likely bounce back in due time.

Individual bonds on the other hand can preserve your principle as long as you hold the bonds to maturity and the entity does not default. This is often done with a bond ladder.  By staggering maturity dates, investors avoid getting locked into a single interest rate. A ladder helps smooth out the effect of fluctuations in interest rates because there are bonds maturing every year or even quarterly, depending on the number of rungs in the ladder. 

Now, what do I personally prefer? Well, it depends on the person's goals, risk tolerance, time horizon, amount of assets, preferences, and so on. For my clients, I often lean towards Bond ETFs with low costs, which follow different bond indexes. 

Here’s my main reason, Active bond funds have done better historically than active stock funds, but picking a bond fund winner over the long haul is still pretty tough.

Just look at the numbers from Morningstar. As of the end of 2022, only about a third of actively managed bond funds beat their benchmark over a 10-year period. And the odds get even worse when you look at the 15- and 20-year periods. Active managers do a bit better in the Corporate Bond category, but it's still a challenge. For some clients with larger assets, I will buy individual bonds using bond ladders if this is what best meets their needs and preferences. 

In general, bond funds and ETFs can be solid choices for those who want to invest in a bunch of bonds without buying them individually and having to do a bunch of research. It's how most folks’ own bonds anyway. Just remember, there's no one-size-fits-all solution and there are many different types of bonds, bond funds and bond ETFs – make sure you do your research –- it's all about what suits your goals and risk tolerance.

Segment 4: Tailoring Bonds to Your Retirement Strategy 

So, which types of bonds or bonds funds are best for retirees? Well, it really depends on what you want the bonds to accomplish and your unique situation. 

Assuming you're retired and have a mix of stocks and bonds, and 50% or more is in stocks, your bonds may best serve as a source of diversification to help reduce volatility and overall portfolio risk. If that's the case, leaning towards Government bonds could make sense. Government bonds have the least correlation to stocks than any other bonds and during major stock market sell offs, Govt bonds often go up in value as stocks go down.  This may be especially important for retirees who rely on regular withdrawals from their investments.

There's a study by Dr. Pfau that I mentioned in my 3rd episode on the 4% rule. He switched up the bond part of the 4% rule, swapping out corporate bonds for Intermediate Government Bonds. The result was a 100% success rate, compared to the 95% from the Trinity Study that used Investment Grade Corporate Bonds.  Retirees may want to take it a step further and have a few years of expenses in very short-term Government bonds, CD’s, Money mkt funds to help you avoid the rollercoaster that was 2022, where bonds were down often by double digits along with stocks. 

However, if you're on the ultra-conservative side and your retirement assets are mostly bonds, a mix of different bond types might be the way to go. That could include Govt bonds, corporate bonds and maybe even some high-yield bond funds, which often offer higher yields compared to Government bonds and investment grade corporate bonds. You might even add some international bond funds as well. The key here is making sure your bond choices match your retirement goals and your comfort level with risk.

In conclusion, bonds can play a crucial role in shaping your retirement strategy. Whether you lean towards bond ladders for principal protection, Government bond funds for overall portfolio stability, diversification and protection, or you prefer to diversify your bond holdings to try and create higher yields and greater returns, the key is to align your choices with your unique financial goals and overall portfolio allocation. Remember, there's no one-size-fits-all answer, but understanding bonds empowers you to make informed decisions for your retirement journey.