Beware the Bond Bomb

The Federal Reserve has not been kind to retirees who tend to use bank CDs and other fixed-income investments to generate income for living expenses.  By pushing interest rates down and keeping them low it has forced retirees to take more risk since they can’t live on a 0.5% or 0.05% return.  The Fed has indicated that they plan to keep rates low for at least the next year, however, so don’t expect things to get any better soon.

We are also starting to see some signs of inflation.  It is true that housing prices have been depressed, but we have seen large increases in energy and food.  Indeed, February is traditionally the lowest priced month for gasoline, and yet we are seeing it over $3.50 per gallon.  A price that would have been unheard of just six years ago.  Expect $5 gas this summer.  Meat at the grocery store is also going through the roof, and produce isn’t far behind.  Maybe we haven’t seen wages grow yet, largely because workers are perennially scared of losing their jobs, but eventually wages will need to rise because people will not be able to buy food and gas to get to work if they don’t.

Because of the low interest rates, and despite the evidence of inflation starting to grow, bond prices have shot up dramatically.  Because bonds pay a fixed interest payment and because people buy them almost exclusively for their interest payment, they are very sensitive to interest rates.  If interest rates go down, as they have recently, people bid the price of bonds up since they are willing to take a lower return because at least it is better than the return they are getting from bank CDs.  When interest rates rise, however, or when inflation increases, wiping out the earnings of bond buyers unless they get a higher interest rate, people won’t buy bonds until the price drops to a point where the interest rate is high enough to justify the risk they take. 

Bond prices are currently extremely low as people have piled into them with money that used to be parked in bank CDs.  When the Federal Reserve raises interest rates to fight inflation, or even if they don’t and decide to let inflation grow, bond prices will fall once again hurting retirees.   Interest rates might remain low, and bond prices remain high, for another year or two. The thing about bubbles is that they last for a lot longer then you think they will.  Eventually, however, all bubbles pop.  It is just a question of the trigger.

Avoiding the bond bubble will be difficult for those who are on fixed incomes.  The fact is, they need to generate income somehow, and therefore they need to accept the high prices of bonds and meager returns because they are better than the returns they can get elsewhere and they need to make a certain amount to cover expenses.  One option would be to go into dividend paying stocks such as drug companies, household product makers, and utilities, as well as REITs, in addition to bonds.  While all of these will decline in price somewhat if interest rates rise, at least there is some diversification and growth in property or business value might offset some of the loss due to interest rate increases.  Because there is something of value that will grow in price with inflation underlying these investments, equities and REITs are better inflation hedges than bonds.

A second option, for those who have enough money to do so, is to invest more in equities and use capital gains for income.  This would involve keeping a portion of investments in equities and then selling off shares of equities for income periodically.  This can be risky because the returns on equities can be unpredictable.  One really needs to have a big enough account to keep several years’  worth of expenses in cash (bank CDs) and still be investing enough to generate enough income to replenish that cash periodically.  This would allow you to hold onto equities and use some of the cash to live on when stock prices decline in a year, and then replenish the cash by selling shares in years when the markets do well.  Overall you will do much better this way than you will with bonds, even in better bond markets, but it requires a substantial amount of savings or the risk is too great.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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