Do Bonds Still Have a Place in Retiree Portfolios?

Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar.com. Bonds have badly lagged stocks over the past decade. And in 2018, rising yields led to falling bond prices. Joining me to discuss the pros and cons of the main bond alternatives is Christine Benz. She is director of personal finance for Morningstar.

Christine, thank you for joining me today.

Christine Benz: Susan, it's great to be here.

Dziubinski: Now, let's step back and start at the beginning. Let's talk about the basic thesis for holding bonds as a component of a portfolio. Why do it?

Benz: The thesis is that in normal environments you should be able to pick up a higher yield than you can on your cash instruments with just a little bit more volatility. So, unlike true cash instruments, your principal is not guaranteed in bonds. But typically, your losses will be nowhere like the sorts of losses that you can incur in stocks.

Dziubinski: And then as one draws closer to retirement and withdrawing these assets, the standard advice is to add more bonds to a portfolio. Why is that?

Benz: Well, the basic idea is that as you get close to needing to spend from your portfolio, you want to try to secure those assets, so that in some sort of catastrophic period that you might encounter during your retirement years, you wouldn't have to tap your equities while they are at a lower ebb. You have enough ideally in cash as well as in bonds to tide you through those rough equity markets that periodically present themselves.

Dziubinski: Now, we're kind of in an interesting period right now, where bonds, whether they are short- or intermediate-term, really aren't giving you much more than you can get from just being in cash. So, why should an investor bother with taking on--even if it's incremental--risk by investing in bonds rather than just staying in cash?

Benz: I think it's a really good question. I think investors should indeed have cash as a component of their in-retirement portfolios or if they have very near-term cash flow needs. By all means, keep that money in cash. But I think the risk of having too large a cash position is that if perhaps bond yields trend down over the next few years, maybe if we encounter some sort of recessionary environment or a weakening economy, that's oftentimes what happens, then the investor in cash will be stuck having to settle for ever lower cash yields. Whereas the bond investor, even though he or she too has to settle for lower yields, you are able to partake in higher bond prices. So, that's a benefit that you can avail yourself of if you are sticking exclusively with cash.

Dziubinski: You recently wrote a column on Morningstar.com about how dividend-paying stocks are really an imperfect substitute for bonds and you hear a lot from readers about that. Let's talk a little bit about what the pros are investing in dividend-paying stocks.

Benz: Right. Our readers love dividend-paying stocks, and I love them too. There are several things to like about dividend-payers. One is that yields right now on sort of a higher-yielding equity portfolio would be higher than what you can earn on a Bloomberg Barclays Aggregate Index product. So, yields are relatively strong. The other big benefit and the thing that people really like about dividend-paying stocks is the ability to actually experience significant capital growth, which is something that you are not going to typically get in a bond product. Those are some of the big advantages. And then favorable tax treatment is another thing to like. So, right now, dividends are taxed anywhere from 0% for taxpayers in the lowest tax bracket up to 20%, way below the ordinary income tax rates that prevail on bond income. So, that's another thing to like.

Dziubinski: But you have to be aware of the trade-off of the different volatility profiles between bonds and dividend-paying stocks?

Benz: You absolutely do. And there's a saying that a bad day in the stock market is like a bad year in the bond market. Stocks are much, much more volatile than bonds. That's the key reason why in my bucketed portfolios, for example, I hold up to eight years' worth of bond investments and two years' worth of cash flows and cash investments. The idea is that you could encounter an Armageddon of an equity market and still have 10 years' worth of cash flows set aside in relatively safe investments.

Dziubinski: Can you offer investors some ideas how they can maintain a decent stake in dividend-paying stocks and still manage their portfolio's risk levels?

Benz: I do hear from investors who are looking to dividend payers to be their cash flow production engine in retirement. And I would say, if that's your strategy, that's something that you'd want to be sure you are augmenting with at least some cash investments. I would also hold some bond investments--maybe not a full eight years' worth of cash flows and bonds, but at least some bond investments. And the other thing I would keep in mind is, to the extent that you have bond investments alongside that dividend-paying equity portfolio, keep it very high quality. You wouldn't want to mess around with some of the lower-quality bond sectors like high-yield, like emerging-markets bond, because you'll have too much volatility there. It's not the right diversifier for your equity-heavy portfolio.

Dziubinski: That makes sense. So, it sounds like there is a place for bonds in a retiree's portfolio.

Benz: There is.

Dziubinski: Thank you for joining us today, Christine.

Benz: Thank you, Susan.

Dziubinski: Thank you for tuning in. I'm Susan Dziubinski for Morningstar.com.