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What Are the Right Bonds for Retirees Today?

It depends on your expectations and time frame.

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Susan Dziubinski: Hi, I'm Susan Dziubinksi with Morningstar. Bond yields are very low right now, but bonds have proven to be decent diversifiers in stock market turbulence. So retirees may be wondering, "What type of bonds should I have in my portfolio today?" Joining me to explore that topic is Christine Benz. Christine is Morningstar's director of personal finance. Christine, thank you for joining us today.

Christine Benz: Susan. It's great to be here.

Dziubinski: Now, let's talk a little bit about the bond market environment today. You know, yields certainly aren't attractive, but you don't necessarily think that's a reason to toss the entire asset class overboard.

Benz: I don't. And I've been saying this for a while, Susan. I think some reframing is in order with respect to fixed-income assets. I think that investors need to get over this idea that they will be big yield or income producers for their portfolio. That ship has sailed over the past decade where we've seen yields really going lower and lower. I think you need to look at bonds as being portfolio stabilizers--sources of cash flow that you can draw upon when your equities are down. I like the idea of retirees building themselves kind of a bulwark against an equity market shock that consists of cash and bonds for that very reason--that they can be sources of cash flow.

Dziubinski: Now, you recently talked to financial planner Jonathan Guyton in one of your podcasts. And during that, he revealed that he's been really using almost exclusively Treasury bonds with his clients because of their diversification value right now. What do you think of that idea?

Benz: Yeah, that dovetails with what I was just talking about because the idea is you're constructing a portfolio for retirement where you'll always have something to draw upon to supply your cash flows. His thought process there was that we've been through several periods now where we've seen Treasuries outperform really everything else. As you remember, Susan, we were all covering and watching bond funds during the first quarter. We saw a lot of bond fund types tumble even as Treasuries really held their ground. And that was also borne out by this recent research that I've been working on, where I've been examining correlations across different asset classes, essentially looking to see, "Well, what is the best antidote to stock market weakness?" And indeed, when we look at the asset class that is among the least correlated with stocks, it is Treasury bonds. So that's his basic finding. It's not something that necessarily every financial advisor would support, but his idea is that he's looking to build his clients that bulwark that they can draw upon in periods of equity market weakness.

Dziubinski: Given the diversification value of Treasuries, do you think that retirees should be broadening their basket of bond exposure beyond Treasuries?

Benz: Well, I like the idea of retirees keeping things pretty simple. And so I do think that you could potentially go with a broader basket of high-quality bonds. The key is really high quality. So Treasuries, corporates, some asset-backed and mortgage-backed bonds, I think, all makes sense as long as the quality is high. And the reason why I would say that many retirees may not want to use a Treasury-only portfolio is that, with Treasuries, you pick up quite a bit of duration risk: interest-rate sensitivity. While there aren't any interest-rate hikes on the horizon anytime soon, we do tend to see these bond and bond fund types be pretty volatile and be pretty directly affected by changes in interest rates. That's one reason why I would rather see retirees run with a broader basket, whether that's a total market index fund or some sort of high-quality intermediate-term bond fund, I think is a good core for retirees.

Dziubinski: Now, there are a lot of different bond-fund categories out there. What are the first steps that retirees should take when trying to figure out what type of bond funds they might need?

Benz: I really liked the idea of using your anticipated spending horizon to inform what types of bond funds you hold. So, this is the Bucket strategy that I often talk about, but basically you're teeing up your cash flows based on your anticipated expenditure from your portfolio. So very near-term expenditures would go in very safe assets, more intermediate-term expenditures might go in bonds, and then your very long-term expenditures, where you have like a 10-year time horizon, can safely go in stocks because over 10-year increments stocks have been pretty reliable. I think time horizon is just a tremendous starting point when thinking about what types of bonds to own.

Dziubinski: If your time horizon is pretty short, if we're talking about that portion of your retirement portfolio that you might need to tap into in the next year, maybe even two years, should a retiree be thinking about putting any of that money in a bond fund or should that be relegated to cash?

Benz: I think that, especially given how close yields are with cash relative to bond funds today, I really don't see a strong case for using bond funds in this context. I like the idea of--really no matter the environment--of retirees holding a couple of years' worth of portfolio withdrawals in true cash investments. Yields are really low there as well, but the basic idea is that you're locking down your expenditures. I would not monkey with bonds in this sort of context.

Dziubinski: And then let's go a further out on the horizon where it may be, "OK, so we have that first couple of years of our anticipated expenses sitting in cash, then now maybe we're looking out three to five years." And what type of bond funds would a retiree be looking to to fill that portion of their portfolio?

Benz: Here, I think you can use some sort of a short-term bond fund. Again, I would keep the quality high because I think you really want to remember why you're holding bonds. You're holding them to be the stabilizers when your equities are down. Anytime you're venturing into lower-quality bonds, you're getting more equitylike performance--even a little bit and you're getting that tendency to move in sympathy with the equity market. So, keep quality high, I think, short term for those years, just beyond when your cash resources are depleted. And then I think you can venture into intermediate-term high-quality bonds for the time horizon beyond that. I like the idea of using a short-term bond index fund or an intermediate-term bond index fund. They are very Treasury-heavy and heavy on other types of government bonds. But again, we see that they really do serve as attractive ballast in periods of equity market weakness. There are also some great actively managed funds that investors can use, whether it's a Pimco Total Return or a Dodge & Cox Income or MetWest Total Return, but bear in mind that those are core-plus type bond funds, which means that they will hold a little bit of lower-quality bond exposure in exchange for picking up a slightly higher yield.

Dziubinski: Let's talk a little bit now about a couple of more-specific bond-fund categories and whether they're useful in retiree portfolios. You've talked a bit in the past about TIPS funds. What role do you think that that particular type of fund has today for retirees?

Benz: I do think that retirees should hold Treasury Inflation-Protected Securities as a portion of their portfolio if they're bucketing their portfolios. I hold TIPS in Bucket 2, so in, sort of, that intermediate-term portion of the cash flow system. But TIPS do provide that inflation protection--that insulation against an unanticipated jump up in inflation. I've tended to use Vanguard Short-Term Inflation-Protected Securities in my model portfolio. I like that there isn't a lot of interest-rate-related noise in those products. They're more or less pure inflation protection, and Vanguard has done some research that supports that general idea. But I do think that they are important to retirees, especially because we've seen a lot of spending at the federal level in an effort to stimulate the economy. Inflation is not on the horizon right now, but I think realistically you have to be prepared for potentially some inflationary shock. It may not materialize, but nonetheless, I think it's worth inflation-adjusting the portion of their portfolios that they have in bonds.

Dziubinski: Another sort of subcategory of bond funds are foreign bond funds. And on the equity side, we often talk about the benefits of a globally diversified portfolio. What's your take on foreign bonds and their role in a retiree portfolio, if any?

Benz: It gets complicated because there are so many different foreign bond-fund types. Most of the research that we've done at Morningstar, as well as some other academic research, would point to, in retirement, the virtue of having a currency-hedged foreign bond exposure. So to the extent that you own foreign bonds--and you do pick up some modest diversification by owning bonds issued by other countries' governments--you would want to make sure that they are hedged out of the foreign currency so you're not getting a lot of currency-related volatility.

I would say that the benefits are extremely modest. For retirees who want to keep things simple, it's probably not a "must own" category. And it's also important to remember that a lot of the broadly diversified, actively managed bond funds do make room for foreign bonds. So, you probably don't need to bolt on an additional holding.

Dziubinski: And then lastly, we haven't really touched on some lower-quality bond-fund types, like an emerging-markets bond fund or a floating-rate bond fund. Do you think these play a role at all in a retiree portfolio?

Benz: Potentially, and retirees naturally like the fact that they have higher yields in an environment where yields are really low today, and these bond-fund types were also really beaten up in the first quarter, although they have come back quite a bit recently.

I think to the extent that you incorporate them into your portfolio, I wouldn't include them as part of this shock-absorber piece, where you've got your 10 years' worth of cash flows. I think of them as the longer-term portion of my portfolio. I'd want to make sure I had a nice long time horizon for them because when we look at their characteristics, even though they don't go down as much, when stocks go down, they do tend to move directionally similar. I think you'd want to be thinking of them as perhaps equity substitutes as opposed to substitutes for your core fixed-income exposure.

Dziubinski: Christine, thank you so much for your time today and your guidance on how retirees should be thinking about their bond allocations.

Benz: Thank you, Susan.

Dziubinski: I'm Susan Dziubinksi with Morningstar. Thanks for tuning in.

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.