According to Fidelity, the number of 401(k) millionaires has recently reached a new record. Not coincidently, the U.S. stock market, as measured by the S&P 500, is also at an all-time high. If you’ve participated in this prosperity, I congratulate you!
If you are someone who has seen their retirement savings blossom and is closing in on retirement, investing in bonds is an increasingly good idea. That’s because the closer you’re to retirement, the more difficult it becomes to replace lost retirement assets with future savings.
The cold hard reality is you never know when the next big stock market sell-off is going to happen. The good news is that understanding the benefits and risks of owning bonds, and the role they can play in your retirement portfolio, can help make your retirement savings more secure as you near retirement.
Bonds versus stocks: historical risk and return
A good way to understand the risk and reward of owning bonds is to compare them to stocks. While both are financial assets issued by a corporation or government, purchasing a share of stock represents taking an ownership interest while buying a bond represents making a loan to a company or government entity.
Over the past 60 years, stocks have delivered an average annual return of 10.7%, while bonds have generated an average yield of 5.8%, as measured by the 10-year Treasury. During that same time period, the risk, or volatility, has been on average about 60% higher owning stocks with a “worst case” decline of around 50% for stocks compared to a 15% drawdown for bonds.
Like any asset, your expected future return depends partially on what you pay. From this perspective, stocks look fairly expensive currently, trading at 21.5 times future earnings, which is more expensive than they’ve been 91% of the time over the past 20 years. Bonds currently yield about 4%, as measured by the 10-year Treasury, which is a higher yield than 84% of the time over the past couple of decades. As such, while stocks are certainly able to go higher for various reasons, allocating more assets into bonds looks relatively attractive right now.
Rising interest rates the primary risk for bonds
The primary risk to owning bonds is rising interest rates. When interest rates go up, the value of existing bonds and bond funds go down. Importantly, if you own individual bonds, you normally can’t lose money if you hold them to maturity. Central banks, like the Federal Reserve, adjust short-term interest rates to control inflation and stimulate economic activity. U.S. government spending and taxation policies affect longer-term interest rates, primarily because they determine how much money the government must borrow.
Investors outside of the U.S. own about 30% of all U.S. bonds, so foreign demand also plays an important role in our bond market. As long as the United States remains a military and economic superpower, there should be ample foreign demand for our government debt, which keeps our interest rates lower. That said, any government that borrows too much threatens its ability to repay the principal and interest on its debt, which would dissuade foreigners from future purchases, causing prices to fall and interest rates to spike.
Investment strategy should consider risk tolerance
If you sit down with a pro and ask about your proper allocation to bonds, the conversation will invariably start with risk tolerance. How much do you need to have accumulated to meet your financial goals? How much time do you have to make up a big loss before you want to start spending your savings? Without such an investigation, the historical rate of return data I’ve already shared suggests everybody would invest 100% in the stock market.
Given now is one of the better times to invest in bonds in the past 20 years, you might be asking, what’s the best way to get started? For anyone over the age of 50, I’d start with a 10% position and move 5% more into bonds every year until you’re at a 50-50 split. The most conservative allocation I generally recommend is a 70% allocation to bonds. Any more than that carries with it the very real risk of losing purchasing power due to inflation.
It’s also important to understand and practice the discipline of rebalancing. I recommend revisiting your portfolio’s stock/bond mix once a year. The next time stocks suffer a steep decline, sell some of your now overweight bond exposure and buy more stocks to rebalance back to the original target weight. Practicing this discipline will force you to buy low and can meaningfully enhance your overall portfolio’s long-term rate of return.
Ultimately, your ideal exposure to bonds should be guided by a careful balancing of the need to secure hard-earned savings and the desire to grow your retirement nest egg. If in doubt, find an experienced financial adviser, preferably one who will work for an hourly rate, to provide guidance.
The material in this column is provided for informational purposes only. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Francis LLC does not offer personal legal advice. Michael J. Francis is president of Francis LLC, a registered investment adviser with offices in Minneapolis, Minnesota, Brookfield, Wisconsin, and St. Louis, Missouri. He can be reached at michael.francis@francisway.com.
