This is the second post in a series on investing in retirement to generate income. The series starts here.
The traditional way to generate income in retirement is to use income assets. The traditional income asset is bonds. A bond is a loan to a company or a municipality (or a country). Bonds have a fixed repayment date, called the maturity date. Unlike a consumer loan where interest plus principle are repaid over time, bonds make interest payments only until the maturity date, at which time the loan is repaid all at once. The interest payments are fixed in dollar terms. For example, a 7.5% bond would typically pay $75 per year for the life of the bond. Because bonds normally pay interest semi-annually, they would pay $37.25 every six months to whomever held the bond.
The price of a bond will fluctuate due to interest rates and the perceived risk of the company not repaying the loan. If interest rates go down, the price of bonds tends to go up. This is because the amount the bond pays out is fixed, so if interest rates elsewhere go down, people are willing to pay more for the bond, thereby getting a lower interest rate than they would have when the bond was cheaper, but still getting a better rate than they would have in other places like a bank savings account. Likewise, if interest rates rise bonds decline in price.
If a company, city, or country is perceived to be a higher credit risk, the price of the bond will decline. In this case the buyer will not take the chance of buying a bond and risking losing his investment unless the interest rate he receives is higher to justify the risk he is taking. As bonds get close to maturity, because the ability of the company to repay the loan gets more predictable and because the loan term is no longer as long, the price of the bond will tend to move towards its coupon level. This is normally $1000 per bond for corporate bonds. If you take a chance and buy a risky bond while it trades for $500 and hold it until it matures, you will be rewarded with both the capital gain from the bond price increasing from $500 to $1000 and the higher interest rate you receive for buying the bond so cheap. Then again, a lot of bonds trading at $500 per bond default, leaving the holder with nothing.
When using bonds for retirement income, you would want to buy a bond fund, which holds hundreds or thousands of bonds, or buy several different bonds. In selecting a bond fund, choosing the one with the lowest cost such as a bond index fund. If you do buy individual bonds as well, you would also want to buy mainly bonds with high credit ratings (basically with a lot of A’s from Moody’s, such as a AA or AAA rated bond). You might buy a few lower quality bonds if you have money you can afford to lose since you can get a higher interest rate and perhaps a capital gain if things work out and the company repays the loan, but expect some of those bonds to default before they mature. If you buy only individual bonds instead of a fund, you would need to spread out your money over several different bonds to reduce your risk of loss should some defaults occur, Unlike stocks where concentration can result in a higher reward, gains on bonds are very limited and there is little reason to concentrate. Getting an extra 0.25% on your money isn’t worth taking the risk of losing $50,000 because you’ve invested a lot in the bonds of one company and that company defaults on its loans.
A rule of thumb is to put you age minus ten percent in bonds and put the rest in equities. Someone who is 70 would therefore be about 60% in bonds and 40% in stocks. It would probably be better to also hold some cash since that would allow you to pay expenses while the market recovers should a downturn occur. So maybe you would hold enough cash to cover 2-5 year’s worth of expenses as well as your stocks and bonds.
When creating an income portfolio, you might also want to find a fund that pays out payments roughly four times a year so that you’ll have a regular source of income. If you are buying individual bonds, you can normally find bonds that pay out on opposite 6-month schedules, such that you will generate interest payments each three months. You may also want to time it so that more bonds pay interest at a certain time of year, for example at the beginning of the summer if you normally take a summer trip and need more cash at that time.
Unfortunately, because the Federal Reserve has been keeping interest rates so low, it is a bad time to buy US corporate bonds. They have already been bid up to high prices because interest rates in other places are so low. When inflation returns and the Federal reserve is forced to raise interest rates back up to more normal level, bond holders could easily see 20-3o% losses in the value of their bonds. They could also see their bonds redeemed by companies who would then refinance the loans into new bonds with lower interest payments, much as a home buyer might refinance his house. If the bond buyer paid more than the coupon rate for the bond, he would lose money when the company repaid the bond since it would only pay back the $1000 per bond. Retirees and others who need income might therefore want to use less traditional methods of generating income, as will be described in future posts in this series.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. 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. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.