Does “Safety” of Principal make sense for you?
You are about to retire, or thinking about it anyway. You’ve just sold your business, or perhaps some of your investment property, and you are now sitting on a rather large pool of money. You don’t want to work anymore . . . better put, you don’t want to have to work anymore. How do you invest these proceeds to generate sufficient income for the rest of your life?
The importance of stable portfolio income, particularly for retirees, cannot be overstated. When properly executed, a strategy that can grow your income over time, can greatly reduce the risk of outliving your savings. But what many investors (and financial advisors) fail to recognize is that the traditional approach to generating portfolio income could very well turn into quite a dangerous endeavor.
Fixed income (bonds) has long been thought of as the hallmark choice as a “safe” way to produce income. And why not? Along with paying a fixed rate of interest over a period of time, high-quality bonds carry implied principal protection. Although they are indeed interest-rate sensitive animals, meaning bond prices tend to fluctuate when interest rates change, it is a widely-held belief that as long as you hold your bond to maturity, you don’t have to worry about loss of principal. Furthermore, the financial industry seems to endorse the idea that by building a “laddered” bond portfolio for an investor, (the act of buying multiple bonds at staggered maturity dates), you can minimize the effect of interest-rate risk on your future income. Sounds reasonable, right?
Timeout. Generating income from your portfolio may very well be the single most important aspect in your investing life. Getting this strategy wrong can be financially devastating, yet the consequences may not be so conspicuous at first. Without the appropriate philosophy, you could be putting your financial well-being at risk without even knowing it.
Of the three possible interest rate scenarios when investing in fixed income, two of them are negative for the investors. And you could make a strong argument that the third possibility isn’t anything to get excited about either. Let’s examine:
Scenario 1: Interest rates rise. This is a scenario some think is quite probable in the near future considering where interest rates are now. There is a possibility that rates could be higher and you could receive more income each year than originally expected. However, this can be problematic. Rising rates are often a fundamental indication that there is inflationary pressure in the economy. Things will cost more. Any apparent increase in your portfolio income could quite possibly be offset by inflation. Therefore you might actually lose purchasing power, even though you are receiving a higher amount of income.
Scenario 2: Interest rates remain the same. Aside from the fact that this scenario is the least probable, the bigger issue at hand is it assumes you will not need a greater amount of income in the future. Unfortunately, in the real world, I think it is quite safe to assume that regular every day expenses are not fixed, rather they tend to rise over long periods of time. Electric bills, cable, gas, food, you name it. The list goes on and on. Things just tend to go up in price over time.
Scenario 3: Interest rates fall. Perhaps the most direct impact. When your bonds are coming due, the options for reinvestment are now at lower rates . . . you will now receive less income. So what happens now, when your portfolio income isn’t enough to meet your needs? If your portfolio was previously generating income of $100k on an annual basis, but is now generating 80k, how do you fill the shortfall? You’ll likely have to dip into principal. And it is at this point when you have effectively lost principal. Let me say that again: you have now lost principal on an investment that was supposed to actually preserve and protect your investment. And if that isn’t enough, corporate bonds often have “call provisions” written into the contract. This means that the issuer can actually force you to redeem your higher-interest paying bond EARLY, so that they can reissue new bonds at the now prevailing lower interest rates.
For an investment option that is widely advertised as safe, fixed income sounds awfully risky to me. Where are interest rates going to be five or ten years from now? Your guess is as good as mine. Perhaps there’s a chance you need more income as time goes along. Given the three possible outcomes for a “high-quality” laddered bond portfolio, I think it bears the question: Is there another way? Comfortable words like “safe” and “secure” could very well turn out to be quite dangerous.
Are bonds appropriate for your portfolio? Are you willing to subordinate the amount of income you receive, in return for the potential of safety of principal? If this doesn’t sit well with you, perhaps you should consider a portfolio that focuses on growth of income, rather than fixed income. Compared to a FDIC-insured CD, there is certainly more risk involved. However, executed properly, you can enjoy growing income over time, as well as the potential for growth of principal.
Disclosure: Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Certificates of deposit are FDIC insured if held to maturity.