Retirees, Break Free From Low Yields

Jim Stringer feels hamstrung by the bond market. Just a year or so away from retirement, the 59-year-old utility system operator has been shifting more of his assets into low-yielding bonds. He already has two years’ worth of living expenses stashed in ultrasafe money market funds that offer little in the way of income. He’s planning to replace some of his stocks and real estate investment trusts with a high-quality short-term bond fund that yields about 2.2%. And he has built a ladder of individual corporate bonds with an average yield of 3.6%.

That level of income doesn’t impress Stringer. If bond yields had been higher in recent years, he says, he’d be retired already. Instead, he’s dividing his time between his family home in De Soto, Mo., and San Francisco, where he works—and trying to squeeze a decent yield out of his fixed-income holdings without taking outsize risks. “It’s absolutely ridiculous how hard it is to generate income,” he says.

Many baby boomers and older retirees would agree. They’ve spent the better part of a decade waiting for higher rates—yet high-quality bond yields remain stubbornly low. Although recent Federal Reserve interest-rate increases have spurred a modest rise in shorter-term bond yields, longer-term yields have barely budged. So investors aren’t getting paid to take on the additional interest-rate risk that comes with holding longer-term bonds. Nor are they compensated for taking on the credit risk that comes with owning bonds from lower-quality issuers. The gap between junk-bond yields and Treasury yields is near historic lows.

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Meanwhile, new risks are coming to the fore. The Fed is starting to trim the massive government- and mortgage-bond holdings it acquired in the wake of the financial crisis, scaling back a major source of demand for those bonds. And tax reform adds an extra dose of uncertainty to the bond market. It could have both positive and negative implications for bonds, depending on how it ultimately takes shape.

All that hasn’t stopped investors from plunging into bond mutual funds. With retiring baby boomers desperate for income, bond funds took in about $201.9 billion in net new money in the first nine months of this year, according to the Investment Company Institute. That’s 64% more than in the same period for 2016.

Such strong demand for bonds, combined with the Fed’s measured approach to rate hikes and subdued inflation, leads many analysts to conclude that bond yields won’t surge higher anytime soon. So what’s an income-focused investor to do?

“Control what you can control,” says Mary Ellen Stanek, chief investment officer at money-management firm Baird Advisors. No, you can’t vote on the Fed’s next rate move. But you can minimize your fund fees, which take a bite directly out of your yield; avoid risks that you’re not paid to take; and get real about bonds’ role in your portfolio—reducing overall volatility and producing some predictable income. “It’s not about getting as much return as you possibly can,” says Michael Goldman, a financial planner in Falmouth, Maine.

That said, you don’t need to lock up your nest egg in 1% prison. You can find higher yields today—and position yourself to benefit from higher rates down the road—without loading up on risk.

Build a Solid Core

Government bond funds may seem like the ultimate haven for retirees seeking safety. But there’s a new uncertainty hanging over U.S. Treasuries and agency mortgage-backed securities: The Fed, which purchased trillions of dollars of such debt in its effort to combat the financial crisis and Great Recession, is now reversing course—allowing some maturing bonds to roll off its balance sheet rather than reinvesting the cash. Although the move has been clearly communicated well in advance, some strategists see potential turbulence ahead for these bonds.

While government bonds and mortgages remain key parts of a bond portfolio, funds that blend these bonds with high-quality corporate debt and other holdings may form a more solid core for your bond allocation. Although their yields won’t blow your hair back, the case for investment-grade corporate bonds is strong. Corporate profits have been healthy, and many companies have ample cash on their balance sheets.

To safeguard against rising rates, many advisers suggest sticking with short- and intermediate-term bond funds. (When rates rise, bond prices fall.) With rates climbing on the short end and going nowhere fast on the longer end, you’re not sacrificing much yield by avoiding longer-term bonds.

The maturities you focus on, however, will depend partly on your time horizon. Money you need in the next year or two should be in cash-like vehicles, such as money market funds. If you have a two- to five-year time horizon, consider low-cost, high-quality ultra-short and short-term bond funds, says Sarah Bush, director of fixed-income manager research at Morningstar. Solid options include ultra-short Fidelity Conservative Income Bond (FCONX) which yields 1.1% and charges fees of 0.35%, and Vanguard Short-Term Corporate Bond exchange-traded fund (VCSH), which yields 2.2% and charges fees of just 0.07%.

If your time horizon is five years or more, look to high-quality intermediate-term bond funds. Baird Core Plus Bond (BCOSX) yields 2.4% and charges 0.55%, while Kiplinger 25 member Metropolitan West Total Return Bond (MWTRX) yields 1.7% and charges 0.67%

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Tackle Interest-Rate and Inflation Risk

Now that many market strategists have spent about eight years predicting rising yields, you may be justifiably skeptical of any attempts to forecast rates. Investors who want to hedge their interest-rate bets might consider a “barbell” approach combining short-term bonds with intermediate-term high-quality corporate bonds, says Dan Heckman, senior fixed-income strategist at US Bank Wealth Management. “Interest rates have befuddled most people through this long cycle, and we don’t think you want to be heavily loaded at one end of the canoe or the other,” he says.

For the short end of the barbell, Heckman suggests using floating-rate securities, whose interest payments reset periodically based on changes in a benchmark rate. Use caution with floating-rate bank loans, which are generally issued by companies with lower credit ratings. Instead, consider investment-grade floating-rate bonds. The iShares Floating Rate Bond ETF (FLOT), which yields 1.4% and charges fees of 0.2%, offers diversified exposure to these bonds.

Many investors, like Stringer, aim to tackle interest-rate risk by building ladders of individual bonds. (If you hold each bond to maturity, you’re guaranteed to get your principal back—barring a default by the issuer.) You might buy equal dollar amounts of bonds maturing in each of the next five years. As each bond matures, you can reinvest in a longer-term bond—taking advantage of rising rates as you extend your ladder.

For greater diversification, build a ladder of “defined maturity” bond funds, which invest in bonds that are set to mature in a particular year. Fidelity, for example, offers defined maturity municipal bond funds with maturity dates of 2019, 2021, 2023 and 2025.

If you can project how much you’ll spend in each of the next several years, it’s possible to design a ladder of high-quality individual bonds that will provide the precise amount of income you need in each of those years. That can free you from angst over the market’s performance, but it can also be a heck of a lot of work.

Asset Dedication, a San Francisco money-management firm, will do the heavy lifting for you. The firm’s Defined Income Portfolio uses certificates of deposit and high-quality individual bonds to build ladders that will precisely match clients’ spending needs over a certain period, typically five to 10 years. The portfolio, available as a separate account through financial advisers, charges annual fees of 0.35%.

Although inflation has been fairly subdued lately, retirees living on a fixed income can’t ignore the risk of rising prices. Today’s low unemployment rate and potential tax cuts are inflationary forces—though other factors, such as baby boomers retiring en masse, should help keep inflation from getting out of hand, analysts say. Michael Arone, chief investment strategist at State Street Global Advisors, suggests tackling inflation by allocating roughly 5% of your total portfolio to a basket of “real assets,” including Treasury inflation-protected securities, natural resources, commodities and real estate. A diversified inflation-fighting mutual fund may help. Pimco All Asset (PASDX) holds TIPS, commodities and other assets, and it aims to beat inflation by five percentage points annually over the long term.

If you are looking to buy and hold individual TIPS, consider five- to 10-year maturities, suggests Kathy Jones, chief fixed-income strategist at the Schwab Center for Financial Research. The “break-even rates” on these bonds, meaning the difference between the TIPS yield and the yield on a traditional Treasury bond of the same maturity, are less than 2%—the Fed’s long-term inflation target. If inflation averages more than the break-even rate, TIPS will outperform traditional Treasuries. “The Fed is determined to get to 2%, and I think it’s getting more realistic to expect that they might,” Jones says.

The Hunt for Yield

There are plenty of bad ways to boost your yield, including taking on outsize interest-rate risk and snapping up low-quality debt. But here’s one good way: Choose lower-cost funds. Mutual fund fees come straight out of your returns, and with high-quality bond funds yielding 2% or 3%, you can’t afford to hand fees of well over 1% to the fund company. Also consider this: To maintain a competitive yield, a higher-cost fund is forced to take on more risk than its peers.

You can also plump up your yield by sprinkling some higher-yielding corporate and emerging-markets bonds into your portfolio. Proceed with caution: These bonds aren’t offering a lot of additional yield in exchange for the extra risks they carry, and some money managers are growing wary. The Baird Core Plus Bond Fund, for example, can invest up to 20% of its assets in “junk” bonds rated below investment grade, but it’s currently devoting only 6% to those holdings, says Warren Pierson, senior portfolio manager at Baird.

Given the high volatility of junk bonds, retirees should consider these holdings part of their stock allocation, Jones says. That way, your bond weighting is reserved for more stable fare. You can also temper your risk by choosing a go-anywhere bond fund that has a proven record of success investing in junk bonds. Loomis Sayles Bond Fund (LSBRX), for example, can invest up to 35% of assets in below-investment-grade holdings. The fund yields 2.8% and charges fees of 0.91%.

When venturing into emerging-markets bonds, be aware that currency swings can give you a wild ride. Consider funds that tame this risk with complex investments that hedge away foreign-currency exposure. Pimco Global Bond (PGBIX), which yields 2.3% and levies annual fees of 0.55%, invests in emerging-markets as well as developed-markets bonds and hedges most of its currency exposure back to the U.S. dollar. Kiplinger 25 member Fidelity New Markets Income (FNMIX), which yields 5.1% and charges fees of 0.86%, tends to keep most of its assets in U.S. dollar-denominated emerging-markets bonds.

Get Tax-Free Income

It may not seem ideal to invest in tax-exempt municipal bonds at a time when tax reform is a top priority in Washington. After all, income-tax cuts reduce the value of municipals’ tax exemption.

The tax plan unveiled by Republican lawmakers in early November, however, paints a fairly benign picture for muni bonds. While many people in higher brackets may see a reduction in their marginal rate, the plan also eliminates a number of deductions. And the muni tax exemption itself doesn’t appear to be on the chopping block. So munis are likely to be “just as valuable” post-tax-reform for individual investors, says John Miller, co-head of fixed income at Nuveen Asset Management.

Tax-exempt bonds aren’t nearly as cheap as they were after last year’s presidential election triggered a broad muni sell-off. AAA-rated 10-year general-obligation muni yields were about 86% of comparable Treasury yields in early November, well below the 107% level reached after the 2016 election. (Prices and yields move in opposite directions.) Still, munis remain “in a fair value zone,” Miller says.

Short-term munis, however, are looking pricey, as “people have been piling in,” Jones says. She prefers intermediate-term munis, “where valuations are more attractive.” Fidelity Intermediate Municipal Income (FLTMX), a member of the Kiplinger 25, avoids big bets on troubled issuers, such as Puerto Rico. The fund yields 2.6% and charges fees of 0.35%.

For investors who can stomach a bit more risk, juicier income is available in some muni closed-end funds that are trading at wide discounts. Because closed-end funds have a fixed number of shares that trade on an exchange, their share prices can diverge from the value of their underlying holdings, whereas traditional mutual funds trade at the value of their portfolio holdings.

These funds tend to get hit hard when rates rise, but Jim Robinson, manager of the Robinson Tax Advantaged Income Fund, likes two muni closed-end funds that have below-average interest-rate exposure and trade at wide discounts. Eaton Vance Municipal Bond (EIM) trades at an 8.7% discount and offers a 5% distribution rate, while Eaton Vance Municipal Bond II (EIV) trades at an 8.6% discount and has a 4.7% distribution rate.