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With Historically Low Yields, Income Investors Rethink Bonds

by David Pilaitis

Sep 1, 2021
September 2021

Yields on high-quality bonds are at a 50-year low, and experienced investors, who might have enjoyed 5 to 10 percent yields on AAA bonds in the 1980s and 1990s, are now earning 1 to 3 percent. This has a dramatic impact on retirement income, creating a dilemma for many investors: Should I stay the course and accept the low yields (and the risk of having my bonds called) or look at other strategies to close the income gap?

Some investors have large retirement nest eggs (or current income from other sources) which affords them the flexibility to maintain status quo with their bond investments. Many others, however, are not so fortunate and need to seek higher yields in order to generate enough income to cover monthly expenses. They are forced to change their approach, hoping to earn enough return in alternative assets to offset the loss in yield.

Classic strategies to achieve higher return include increasing stock (equity) exposure; buying high-yield bonds, real estate investment trusts or master limited partnerships; or buying private pensions (single-premium immediate annuities).

Every product or strategy has pros and cons, and four out of these five examples increase investment risk. Buying an annuity is something many investors simply will not entertain given the liquidity constraints of the products.

Investors own bonds for two core reasons: to generate income and provide safety of principal. While high-quality bonds continue to provide safety — acting like an insurance policy in portfolios by providing protection against loss — today’s environment essentially changes the income calculus, decreasing the premium (yield) one receives.

Simply put, the cost of the insurance (bonds) increased, and investors need to think differently about risk profile, yield and protection. Furthermore, advisors who continue to recommend traditional portfolios that predominantly use bonds to buffer equity volatility and who charge fees for this advice might rethink their value proposition. For example, if bonds yield 1.5 percent per year and an advisor charges 0.5 percent for advice, the advisor is earning 33 percent of the return (assuming little to no growth on the bonds over the next five to seven years). Some argue this is not a fair revenue-sharing model.

The ideal investment strategy will vary based on individual income needs and risk profile, but given the current low interest rate, it seems rational for investors to challenge the conventional use of bonds. They should question whether it makes sense to keep or acquire bonds with historically low returns in their portfolios.

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