Income-Seekers: These 'Myths' Could Come Back to Haunt You
A chronically low interest-rate environment breeds confusion about what we're supposed to be doing.
It's late in a decades-long bond rally, and it's safe to say that the current, ultralow interest-rate environment is messing with our heads.
Who, at the outset of 2014, would have guessed that bonds would put on such a rally? And fewer still predicted that long-term government bonds--deeply unloved by most investors for their extreme sensitivity to interest-rate changes--would be the best-performing category this year, gaining more than 20%. With interest rates so low, you need to whip out an electron microscope to see the yield on your core bond fund, never mind cash.
Ongoing low interest rates have left many income-oriented investors scrambling for yield and have challenged the conventional wisdom about what an in-retirement portfolio should look like. The rate environment has also given rise to a lot of questions. If interest rates rise, where should bond investors go for insulation? Will individual bonds, dividend-paying stocks, and/or cash be safer than the core bond funds that so many investors have been counseled to hold? Does the 4% rule still work, given how low bond yields are?
The answers to these questions aren't clear-cut, which in turn leaves plenty of room for confusion. Here are a few of the myths that are swirling around income-producing securities right now. Granted, not all are out-and-out falsehoods; some of them may hold up in certain situations. But at a minimum, investors shouldn't accept them without first thinking through their own situations, especially their time horizons.
Myth 1: If rates are going to rise, you're always better off buying individual bonds than bond funds.
This one comes up a lot. And it's not as though there isn't a grain of truth to it--there's more than a grain. If you buy an individual bond at the time of issuance and hold it until maturity, you will get your money back in the end, as well as your interest payments along the way--assuming you bought the bond from a creditworthy issuer. By contrast, you won't always get the same amount back from your bond fund that you put in. For example, say you put money into a long-term bond fund and interest rates shot up by two percentage points between the time of your purchase and the time you sell. It's very likely the bonds in the portfolio would have declined in value over your holding period, even if the yield on your fund perked up. (Of course, the opposite can also happen; rates can go down, as they have this year, and the bond-fund holder may see his or her principal value grow, even as the fund's yield has declined.)
For some investors, that might seem like an out-and-out indictment of bond funds, especially given the likely long-term direction of interest rates: up. But while buying and holding individual bonds may help you circumvent one type of risk that the bond-fund holder would confront head-on, you could still face an opportunity cost, which is also a risk. If rates head upward and you're determined to not take a loss on your bond, you're stuck with it until maturity. Meanwhile, as the various bonds in a fund's portfolio mature (and even if they don't), the bond fund can take advantage of new, higher-yielding bonds as they come to market. That helps offset any principal losses the fund incurs as rates go up.
Individual bond buyers can do something similar by building bond ladders, purchasing bonds of varying maturities to help ensure that they can take advantage of varying interest-rate environments. But it may take a lot of money to both ladder a bond portfolio and obtain adequate diversification across varying bond types. And by the time the investor does, the portfolio may look an awful lot like--you guessed it--a bond fund. Individual bond buyers may also face sizable trading costs. (This article discusses some of the risks of buying individual bonds.) Of course, an individual may still opt to buy individual bonds rather than a bond fund, but it's not true to say that doing so is automatically less risky than buying a fund. It's a trade-off.
Myth 2: Dividend-paying stocks are safer than bonds.
In a related vein, some investors have dumped bonds altogether, supplanting them with dividend-paying stocks.
With dividend payers, you're not only able to pick up some income, but you may also gain some capital appreciation if the stock increases in value over your holding period; your company may also increase its dividend over time. For people with longer time horizons, dividend-paying stocks--and perhaps all stocks--are quite safe, in that stocks have generated a positive return in rolling 10-year periods roughly 95% of the time.
But as with buying individual bonds, there's a trade-off involved. Of course, stocks, even high-quality dividend payers, have much higher volatility than bonds, as discussed here, making them poor choices for investors who may need to pull their money out in less than 10 years. Moreover, stocks won't be impervious to interest-rate increases, and because investors have been increasingly using dividend payers as a bond substitute, they may be vulnerable to selling if rates head up and bonds become a more compelling alternative. (Income-rich securities like utilities stocks and REITs felt the heat when rates jumped up in the summer of 2013, for example.) Finally, it's worth noting that companies can cut their dividends in times of distress, as was painfully apparent to many dividend-dependent investors during the financial crisis. For these reasons, I've argued that investors might reasonably steer a portion of their bond portfolios to dividend payers (especially if they have a long enough time horizon to ride out the bumps), but it shouldn't be the whole kitty.
Myth 3: Cash is safer than bonds.
This one is, of course, technically true. After all, FDIC-insured cash instruments guarantee that you won't lose money, and that's not an assurance you have with any sort of bond fund, even one that's ultrashort. If you have money you can't afford to lose because you're going to use it to pay next year's tuition payment, your property tax bill, or your in-retirement living expenses for 2015, it's best not to nudge out on the risk spectrum and into bonds. That holds true regardless of the prospective direction of interest rates.
But if your time horizon is longer, sinking too much into cash means that you're virtually guaranteed to lose money once inflation is factored in. Investors might say that they'll steer their bond money to cash for only as long as it takes interest rates to go back to more meaningful levels and the threat of an interest-rate shock has subsided. But how will they know when that is? As with any market inflection point, there won't be clanging bells letting you know it's OK to get back into bonds. Instead, a better strategy is to match your time horizon to the duration of your bond holdings: very short-term assets in cash, intermediate-term assets (with a time horizon of, say, three to 10 years) in core bond types, and long-term assets in a diversified equity portfolio.
Myth 4: Income distributions don't count as part of your withdrawal rate.
In contrast with the preceding three assertions, which may be true in some situations, this one is not true at all. And yet I've heard investors say that because they're spending only their portfolios' income distributions, their withdrawal rates are zero.
It's no wonder there's so much confusion about withdrawal rates during retirement. The word "withdrawal" is part of the problem. (That's one reason I prefer "spending rate" to "withdrawal rate.") People often assume that if they're using, say, the "4% withdrawal rule," that means they can withdraw 4% of their principal. Meanwhile, any income distributions they're able to get out of their portfolios amount to extra spending money.
In reality, that 4% is meant to be an all-in distribution rate--that is, your distributions can come from either or both--income and capital gain distributions, and you're in the safe zone if that total is less than 4%. The reason is that any income that isn't reinvested in the portfolio reduces the portfolio's growth rate just as much as withdrawing 4% of a portfolio after reinvesting those dividends. For more details on the 4% rule, see this article.
Christine Benz will be delivering the keynote address at the Chicago Financial Planning Day this coming Saturday, Oct. 25, 2014. For more details, click here.