Retirement is near, your 401k is looking great from all those years of hard work and all you want is to draw a little interest off of your hard earned assets with as little risk as possible. So:
Where should I Rollover my 401k and where should I invest for retirement?
For many people, the answer to this is bonds.
Bonds are trumpeted as one of the safest investments everywhere you look, but are bonds really safe?
Your parents told you, the advisor down the street probably told you, and the licensing exams financial advisors took said bonds are the safe play for conservative investors!
Well this is going to be a short article … I’m going to buy some bonds and and call it a retirement.
Ok…hold your horses..Slow down and lets start using the left hemisphere of our brain ok water boy?
Before we decide our best friend, financial advisor, or family member’s financial advice is made of gold let’s dig into how bonds behave and make an independent decision about their safety as of 2014!
If you buy or hold bonds you basically become a bank. You are lending money to the bond issuer who will promise to return your money at a specified time and pay you interest while you let them use your funds. For example, North Carolina needs to raise some cash for some projects some up. So they issue some North Carolina bonds to the public. Joe Investor buys some North Carolina bonds and receives regular interest payments (as long as the North Carolina Bonds can pay) from apple until the bond expires or in come cases is called.
How Much Do Bonds Pay?
Typically the rate the issuer pays you is fixed at issuance and is determined based on a number of variables including the risk of the bond issuer (the company or government entity who will hold your money), the risk free interest rate, and the amount of time the issuer will hold your money. So how much do Bonds pay? The so called safest 10 year is currently paying 2.6%.
An Inverse Relationship
Bond prices and interest rates have an “inverse relationship” meaning, when one goes up, the other goes down.
If you invest $300,000 into a 10 year bond paying 6% you stand to earn $18,000 per year which sounds great right now, but what if a few years from now rates rise and new bonds with the same face value and risk are paying 8%? Your $300,000 could be earning you closer to $24,000 per year! In order for you to earn more interest you would have to sell your bond at a significant loss to trade up to a higher yielding bond with the same risk.
Of course, if rates fall and you invest $300,000 into that same 10 year bond paying 6% you could sell your bond early for a profit and look for a new investment.
Again, with interest rates at historical lows where will they go in the future and what does that mean for your bond holdings?
Although it may take some time, rates will rise in the future and if this happens sooner than later it will create a big problem for those who have liquidity needs or are chasing higher interest but currently hold existing bonds/bond funds. Just look at what FINRA (regulatory authority) has to say about the impact of rising rates.
READ THE HIGHLIGHTED SECTION.
If you hold a corporate bond with a duration of 8.4 and interest rates rise 2% you could lose 15% of your value if you need to sell your bond. We saw a nearly 2% change from last May through the end of the year… imagine if 10 year rates go back to normal or worse go to double digits… the losses can stack up very quickly. Click here for the detailed report.
So…are Bonds Safe?
For a long time the answer was yes…hell bonds have been in a bull market since the 1980’s!
Now, I’m not so sure. Regardless of what I think remember the relationship between rates and bond values. For 30+ years rates have steadily dropped to where they are today.. roughly 2.5% on the 10-year. This is why baby boomers put so much trust in bonds. The problem is that history won’t likely repeat itself and the reason is in the chart below!
For the non expert…. the green line represents an interest rate of zero. Zero is the lowest point for interest rates… again we are only roughly 2.5% away from that floor! Remember if interest rates rise bond values fall.
Since interest rates will stop dropping at zero the only questions are:
- How much will they rise
- When will they rise
Ok Jason this sounds boring… what’s this mean to me?
It means anyone who plans to invest in bonds right now is playing against a stacked deck. To get any type of decent interest (5%+) you have to take on more risk than you would have in the past to get the same interest.
So if you are close to retirement and asking yourself:
- Should I invest in bonds?
- Where should I rollover my 401k?
- Where should I invest?
Ask yourself how you will feel if your neighbor is getting 6% in an FDIC insured CD while you are seeing a 35% loss on your bonds and only getting a 4% payout each year. This is a scenario that could be very real in the future if 10 year rates get back to a measly 6%.
Before you get emotional and tell me how safe bonds are just step back and use logic.
Think about the odds of your success with rates so close to 0% and decide if you want to be the house or the schmuck’s going to the casino.
Yes you can hold the bond to maturity and yes as long as the bond doesn’t default you will get your original investment back. But, if you hold bonds inside mutual funds it may not be your choice to hold on…if investors inside of mutual funds with heavy bond holdings start selling because they are seeing losses in their accounts fund managers will be forced to sell holdings…this may not be a big deal.. but if it becomes contagious people holding bonds and bond funds will start to see some pretty ugly numbers in a hurry.
Ok Professor But The Fed will raise rates when they want so losses will happen slow and nobody will be forced to sell:
The Fed has been printing money faster than the ink can dry and although their plan is to slowly increase rates, inflation may force their hand sooner than they want and ultimately force them to raise rates sooner and faster then they anticipated.
If you are invested in bonds, bond funds, balanced funds, target date funds or have an advisor that uses bonds to hedge your risk you better understand what you are getting into.
If your mutual funds have the name:
- Income Builder
- High Yield
- Target Date
Consider hearing a 2nd opinion from someone who thinks bonds could burn you in the near future. Also, click the link below for an articl from CNBC where Soc Gen talks about their prediction of the 10 year at 6% by 2017 CNBC.
Ok Professor I get it. You’re scared bonds could let people down over the next 10 years…so where should I invest?
- Tactical Asset Allocation Programs?
To answer that question one would need a lot more information about you. Feel free to ask us questions below.
If you couldn’t understand to this point, our answer to the question: Are bonds safe is as follows:
Due to the low interest rate environment we believe bonds are not only a silly investment in 2014, they are also quite risky.
- Should I Invest in bonds: Not right now
- Are bonds a safe investment: Not right now
- Are bonds safe CD Alternatives: Not right now
- Are bonds safe Annuity Alternatives: Are annuities safe?
- Where should I rollover my 401k: Not in bonds right now!
Now what? If you have a concern about any part of your portfolio then I would suggest getting a second pair of eyes on your investments.
Let a professional learn about your investment goals and determine if the investments you have are in line with your objectives.
Of course you can CALL 980.233.9770 or EMAIL firstname.lastname@example.org and we will be happy to offer you a FREE 2nd opinion.
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