Should retirees be concerned about investing in bonds?

Often, I hear retirees say that they are too old to invest in stocks and are seeking to invest all their funds in conservative investments such as bonds. They describe themselves as risk-averse. Some will seek to get the highest rates available on bonds without recognising that bonds can be risky.

I am aware that several retirees have been hurt by investing in bonds that have proven to be quite risky. Today, I will examine the pros and cons of investing in bonds and the approach retirees should take when investing.

Bonds offer better returns than regular savings accounts, conservative or short-term investments, such as treasury bills, repurchase agreements and certificates of deposits, and commercial paper. When interest rates rise, bond prices tend to fall.

There is no risk-free investment. The issuer may call the bond. In other words, the bond issuer may opt to repay the investor before the bond’s maturity date, resulting in a loss of earnings for the investor, who will no longer receive interest payments.

The issuer may call in the bond because interest rates have declined, which provides an opportunity for the refinancing of the debt at a reduced rate. Bondholders/investors need to understand the terms and conditions of each bond.

Longer-term bonds are riskier than short-term bonds. Bonds can be issued by the Government or private sector entities. Short-term bonds generally mature between 1 year amd 5 years. Long-term bonds usually have maturity dates of 10 years or longer. They are more susceptible to changes in market interest rates.

The rates offered to bondholders for long-term bonds are higher than short-term bonds. The risk is generally less for short-term bonds; hence, the interest rate tends to be lower.

Credit risk is greater for longer-term bonds as the likelihood of default by the issuer is greater when bonds have much longer maturity dates, which can span decades.

Short-term bonds are more liquid as they can be easily converted to cash, whereas long-term bonds are less liquid, particularly during times of economic instability. Hence, the interest on long-term bonds compensates for the liquidity risk.

Short-term bonds are likely to outperform long-term bonds when interest rates are rising, while long-term bonds generally outperform short-term bonds at times when interest rates are falling, as bond yields are higher over a longer period.

The challenge for some bondholders is how to earn the most attractive returns on their investments. I had an interesting conversation with a bondholder last year. He described himself as risk-averse. He invested only in bonds for his short-term and long-term goals. This decision keeps him busy watching the bond market for new bonds. Whenever a new bond was issued that had a higher rate he would sell the existing bond in pursuit of a higher rate from the newer bond. Though there was a penalty for selling the bond before the maturity date, he believed that the higher return from the new bond would compensate for any loss in earnings from selling the old bond.

A better strategy for this bond investor would be to diversify his bond portfolio by ensuring that the bonds he invests in all have different maturity dates. He would be in a better position to manage interest rate risks, credit risks, and income risks.

Retirees who avoid investing in stocks and choose to invest in bonds because of the fear of loss run the risk of outliving their money. Medical advancement and improvement in health care, physical fitness, and nutrition have contributed to people living longer. Keeping all funds in low-risk or short-term investments is a greater risk than investing in the stock market. Stocks are only risky in the short-term. Investing in a diversified equity/stock fund will beat inflation in the long term. Stocks are ideal for time horizons of 10 years and longer.

Retirees should have a balanced or diversified portfolio of stocks and bonds. Stocks are necessary for growth, while bonds are important for stability. A diversified portfolio of stocks means investing in different companies that are located in different sectors and geographical locations. Investing in a fund of local and global stocks for the long term can be most rewarding to investors, as risks are spread and returns maximised.

The bottom line is, stocks increase returns on investments in the long term. A retiree’s greatest risk is longevity. The greatest fear of retirees is outliving their money.

What percentage of stocks should be contained in a retiree’s investment portfolio? There are several approaches. There are two rules of thumb. One is the “100 minus your age”, which involves subtracting your age from 100. For example, if you are age 65, your stock allocation is (100-65), which means 35 percent of your investment portfolio should be invested in stocks and 65 percent in bonds.

The other rule requires subtracting your age from 110. Therefore, at age 65, 45 per cent of your investment should be allocated to stocks and 65 per cent to bonds. Stock allocation is never a one-size-fits-all. Allocation will also be dependent on other factors, such as the retiree’s current situation, financial goals, and risk tolerance. In the long term, when additional cash is needed, shares/stocks can be sold to provide liquidity.

According to world-renowned investor Warren Buffett, stocks will provide higher returns in the long run than cash or bonds.

Grace G McLean is a financial advisor and retirement specialist at BPM Financial Limited. Contact her at gmclean@bpmfinancial or visit the website: www.bpmfinancial.com. She is also a podcaster for Living Above Self. E-mail her at livingaboveself@gmail.com.