Question: Should I buy bonds in my retirement portfolio? There are obviously some similarities between bonds and bond funds, but their differences are even more important. Individual bonds have a set maturity date and a set interest rate if held to maturity. Bond mutual funds have neither. What advice would you give in today’s market to a retiree buying bonds or bond mutual funds?
Answer: As you pointed out, there are some major differences between individual bonds and bond mutual funds. Bonds have defined yields and defined maturity dates, although some can be called early. If you were to buy a 10-year Treasury Note today, you would know the bond will mature in 2025 and yield about 2.18% per year.
I use individual bonds in portfolios to meet specific goals and bond funds for more general goals. Here is a simplified example of how they might be used in a hypothetical retirement portfolio.
Let’s say you plan to retire next month and you ask me for an investment plan. You have $1.2 Million in an IRA account and you need $50,000 per year of income, in today’s dollars, for the rest of your life.
We would write an investment policy statement (IPS) for your account that would state your targeted rate of return to meet your income goals and describe the risks you need to take to meet these goals. The IPS would state that you want to keep ahead of inflation and that you are willing to invest in bonds, stocks, exchange-traded funds, and mutual funds. It would also state that you understand that portfolios of stocks, bonds, exchange-traded funds, and mutual funds are volatile and that there are periods of time when your portfolio will go up and periods of time when it will go down. The time horizon for your portfolio would be 10 years or longer because you plan to live at least that long.
The IPS would then define your investment allocation. Since we know that stocks might go down before they go up, we would lock in your income for the next five years by allocating $50,000 to a money market fund and purchasing at least $200,000 of short-duration fixed income securities. If we were in a high interest rate environment, we might purchase four $50,000 bonds that would mature at approximately the end of each year for the next four years, generating $50,000 plus interest each year. With today’s low rates, we would invest in shorter duration fixed income mutual funds.
With the other $950,000 we would build a portfolio of equity (stock) and bond mutual funds with an average annual expected rate of return of at least 5% plus inflation. We would let this portfolio grow over the next five years without making any withdrawals. We would divide the portfolio up into various equity and fixed income asset classes and use bond mutual funds for the fixed income asset classes. Bond mutual funds would provide ample diversification to reduce credit risk.
Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment advisor and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning. Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to firstname.lastname@example.org.