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Bonds in the Balance

By Steve Giles                        

Bonds give us the courage and confidence to own stocks. Bonds are important for generating income for retirees. Bonds are also important for distribution strategies. More importantly, bonds provide much-needed non-correlation to stocks to help smooth out the volatility with downside protection. 

At Landaas & Company, we have always preached a balanced approach. We have designed thousands of portfolios that provide our clients with current income, downside protection as well as longer-term growth and upside potential. 

When launching a retirement, distribution planning must include bonds. Studies have shown that most investors do not need more than half their money in stocks to have a successful retirement. Portfolios with much more than 50% in stocks are only increasing their volatility. For the 30 years from 1981 to 2010, a 100% stock portfolio invested in the S&P 500 generated a 10.6% annual rate of return. Over the same period, a portfolio of 40% stocks and 60% bonds generated a 10.7% return – with 40% less volatility.

A properly designed portfolio starts with downside protection and risk reduction. In retirement, a 4%-5% yearly withdrawal rate can usually be maintained when a portfolio is properly constructed using a balanced approach that includes both stocks and bonds. Problems arise for retirees with 100% stock portfolios when the market experiences a correction because it forces the account owner to sell at a loss to maintain their withdrawal rate. 

When we launch retirements, we like to have enough money set aside in bonds and fixed income to provide 10 years of distributions. That way, no matter how the market behaves, our clients are comforted knowing that their cash flow needs have been satisfied for at least a decade. A balanced allocation removes the risk of needing to sell a stock investment at a loss. Instead, during years of market underperformance, we can lean on the fixed-income portion to maintain the withdrawal rate. And during years of market outperformance, we can trim our winners to replace what we have distributed from our bonds. 

For the last 25 years, a low-inflationary, strong-growth environment has made it easier to construct balanced portfolios. However, moving forward, inflation is bound to rise, and along with it we should see higher interest rates. 

Using mainly stocks and bonds, we had the best of both worlds. Stocks provided growth and appreciation while bonds provided income and protection. But, potentially higher rates will challenge the conventional role of bonds in investment portfolios. Because bonds serve as risk reducers, the right approach in the future will be to properly diversify within the bond market in order to maintain our target 5% withdrawal rate. 

Right now, we plan to keep durations relatively short with the expectation that rising rates will create a headwind for total return on our bonds. We caution our clients about chasing yield on the longer-term bonds. Instead, we favor durations in the 4-6 year range. Another prudent strategy for bond investors during rising rate cycles is a laddered approach. As shorter-term bonds come due, they can be replaced at the higher rates farther down the ladder. 

Of course, plenty of economists and analysts think rates could stay low for years into the future. It is not a given that rates will rise, and sluggish economic growth could create an environment where rates stay relatively low. If that is the case, another way to stay diversified within the bond market is to include more non-traditional bond offerings.  We have been finding attractive valuations in lower-quality, high-yield bonds as well as international and emerging-market bonds. Further, reductions in spending at the state and local levels have helped improve the quality of tax-free municipal bonds. And, a possible shortage in corporate bonds could serve to push values higher.

While we cannot control the markets, we can certainly control our allocations. Using stocks and bonds together in balanced portfolios is critical to the longer-term success of maintaining withdrawal rates through retirement. Focus on stocks for longer-term appreciation and growth, but also own bonds for current income, risk reduction and downside protection. Own stocks and bonds for the right reasons – but own both.

Steve Giles is vice president at Landaas & Company.

initially posted April 26, 2012

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