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How Rising Interest Rates Affect Retirees

Christine Benz
Jeremy Glaser

Jeremy Glaser: For Morningstar I'm Jeremy Glaser. Interest rates have been on the rise in 2018 after being placid for quite some time. I'm here with Christine Benz, she's our director of personal finance, to see what this means for retirees.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: Let's start by thinking about kind of the most obvious impact of rising rates which is on bond prices. Can you tell us why rising rates mean that bond prices fall?

Benz: The simple reason is that when higher yields come online that depresses the value of already existing bonds, because they have lower yields attached to them. You tend to see this inverse relationship when yields go up, bond prices go down and the opposite also happens. When yields go down bond prices go up, and that’s the great tailwind that bond fund investors have had over the past several decades, where we've seen declining yields and rising bond prices. Right now we are starting to see a little bit of the opposite effect.

Glaser: Not all bonds are created equal. What categories have been hit particularly hard?

Benz: When we look at bond fund category performance so far here in 2018. As you would expect the long-term bonds have been hit particularly hard, long government bonds tend to be especially interest-rate sensitive. Long-term core bond funds have also been hit hard. Even core-type intermediate-term funds have taken a little bit of hit to principal even as higher yields have come online.

Glaser: We're talking about bond funds here. Investors say OK, well if it's going to hurt my bond fund then why don't I just hold individual bonds, holding it to maturity then I don't need to care about what happens with interest rates. Why would that be a good or bad strategy?

Benz: It's great question and one that I get an awful lot. The fact is that if you are buying say Treasury bonds or very high-quality corporate bonds that can be a sensible strategy. Once you move beyond those very high-quality bonds though I think that there are some risks that start to crop up. One is that it can be difficult to research some of the less frequently traded credits, and it might also be difficult to build a well-diversified portfolio of individual credits, especially if you are a smaller investor who is not buying thousands and thousands of dollars in individual bonds. Then another thing to keep in mind is that bid-ask spreads can come into play, and in talking this through with some of our manager research analysts, it seems that the municipal space--so people who are buying and selling individual municipal bonds--would be especially vulnerable to steep bid-ask spreads that can actually take out a chunk out of the yields that they receive. That's another thing to bear in mind.

Glaser: Another area investors might look at to try to get away from interest-rate risk is to take on more credit risks--buy riskier bonds or maybe non-dollar denominated bonds. Those have been holding up better so far this year.

Benz: They have, they have been performing really well. When we look at the top performing bond category so far in 2018 despite this little bit of interest-rate disruption, we've seen emerging-markets local currency-denominated bonds perform very well, emerging-markets bond funds in general have performed really well. High-yield bonds, bank-loan investments, or floating-rate investments--all of these categories have done really well. That's in large part because people are pretty sanguine about the strength of the economy, strength of the global economy for that matter. These bonds have held their ground pretty well, and of course they do have higher yields attached to them to begin with, so that tends to provide a little bit of a cushion even when we see interest rates jump up.

Glaser: If you are worried about losses in bonds, why not just hold cash?

Benz: A couple of key reasons. I would say actually that the opportunity cost of holding cash has never been lower, because when we look at the differential between even say high-quality short-term bond fund and true FDIC-insured cash instruments today, it's really, really low. You can find an online savings account with a 1.5% yield today, a high-quality short-term bond fund might be yielding like 1.7%, 1.8%, if you are lucky, that's a pretty slim margin considering that the cash instrument is FDIC insured. I think investors, if they do have very near-term expenses that they are going to have to meet--and this is certainly case for retirees looking to build cash flow for retirement--you probably do want to hold that money in cash rather than venturing out and taking even a little bit of risk with some sort of a bond fund, even a short-term bond fund.

Glaser: How do you figure out that balance of how much cash you need?

Benz: I always say that investor should use their cash flow needs to dictate how much to hold in cash. As you know I write and talk a lot about this Bucket strategy for retirement portfolio construction. The starting point that I tell investors to use is to think about their portfolio withdrawal needs, and put like six months to two years' worth of those withdrawals in cash. The rest can kind of get staged by withdrawal timeline. Maybe the next three to eight or three to 10 years' worth of withdrawal needs in bonds, and then the remainder can go into higher returning, higher risk assets, namely stocks.

Glaser: You said you could find potentially 1.5% in an online savings account. How do you figure out where that cash should go? I know a lot of sweep accounts and in brokerage accounts are still going to be pretty low, at least in terms of interest.

Benz: That's right. For investors who have gotten complacent about their cash just sort of figuring that this is dead money, why should I bother, it's time to get out there and take a look at what your cash investments are yielding today. Online savings accounts, in my view, offer the best balance of that daily liquidity, check writing in some cases as well as a pretty decent yield today, as you said of about 1.5%. Money market mutual funds have historically been able to offer higher yields in part because you don't get those FDIC protections. Even though money market funds are now governed by tighter strictures than was the case, say a decade ago, you still need to bear in mind that those are not FDIC insured. There is a trade-off even though in some cases you are able to pickup higher yields.

Glaser: Finally let's talk about debt. Higher rates means higher rates on debt as well. If you are holding debt in retirement, how do you think about that payoff if you do have cash?

Benz: Think about the variability, and this is especially true for people who might hold home equity lines of credit into retirement who are still servicing those debts. I think the combination of the fact that we're seeing yields trend up as well as the new tax laws which effect the deductibility of home equity interest, should really make many retirees take another look at whether they want to be carrying that debt around. I also think its valuable to look at the complexion of your investment portfolio, look at the return prospects of that investment portfolio. If your portfolio's return prospects are muted, to me that accentuates the value of prepaying debt rather than letting it ride.

Glaser: Christine, thanks for your thoughts on rising rates today.

Benz: Thank you Jeremy.

Glaser: From Morningstar I'm Jeremy Glaser. Thanks for watching.