Bonds, the seemingly boring and inscrutable partner to equities, don’t usually generate much excitement. But they play important roles in portfolio planning, offering diversification and fixed-income opportunities.
The wide variety of bond instruments provides the opportunity for age-appropriate strategies throughout the client’s life span. CNBC consulted with several advisors on how they employ bonds when working with pre-retirees.
“I like individual bonds, but I don’t like bond funds, because of the fluctuation of the principal,” said Helen Simon, certified financial planner, retirement management analyst and CEO of Personal Business Management Services.
She uses individual bonds to bridge the time between when clients retire and when they start taking money out of their qualified accounts, such as 401(k) plans, individual retirement accounts and pensions.
“I like to use zero coupon tax-free municipal bonds because when the money comes through, it is all tax-free,” she said.
Zero coupon bonds, long-term fixed-income securities, are purchased at a deep discount and pay out interest only once, at maturity.
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Simon purchases these securities for her clients monthly, creating a “bond ladder.”
“The ideal situation being bonds coming due monthly or close thereto once the client begins tapping their retirement income stream,” she said.
For example, a 45-year-old client who wished to make $10,000 a month available at age 60 could assign a bucket of cash to start purchasing zero coupon bonds through the next 15 years that mature monthly.
The client could purchase a bond today with a 5 percent coupon (interest) rate for $4,800, which will yield $10,000 tax-free when it matures in 2030. Similarly, a 20-year bond at 5 percent, purchased for $3,750, will yield $10,000 in 2045 tax-free.
“A 40- to 50-year-old should consider more than age and time to retirement but also market conditions,” said R. M. Zalatimo, managing director, National Securities Corp.
“We are in a potential rising-interest-rate environment, and initially this will have a negative impact on bond and equity markets,” he said. “If interest rates go up, your bond portfolios will drop in value and you will take a loss.”
For example, a 4 percent corporate bond can only sell at a discount if next year’s bonds are offered at 5 percent, Zalatimo said.
Therefore, to increase liquidity, he advises pre-retirees to reduce their bond portfolio duration to short-term positions of five to seven years.
“I wouldn’t recommend too large of a percentage of investment in bonds prior to 10 years before retirement.”
Other advisors suggest even shorter terms.
Herb White, CFP and president of Life Certain Wealth Strategies, advises his pre-retiree clients to hold short-term (one- to three-year) or intermediate (three- to five-year) positions in bonds.
“As an overall strategy, you still need equities for growth, but you don’t want to overlook bonds,” he said.
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Zalatimo at National Securities also suggests looking into convertible bonds—corporate bonds that can be converted into its issuer’s common stock.
“This is an overlooked asset class,” he said. “It reduces exposure to the market by converting to stock later when the market may be better.
“It gives the income and stability of a bond with the potential for appreciation from the stock market,” Zalatimo said. “It allows you to increase your exposure to bonds, but not necessarily lose out” in times of low yield.
Increase and diversify
“I wouldn’t recommend too large of a percentage of investment in bonds prior to 10 years before retirement,” said Russell D. Francis, CPA, CFP and owner of Portland Fixed Income Specialists.
When clients reach ages 50 to 55, he starts shifting their investments toward bonds, gradually increasing the percentages from about 30 percent bonds to about 60 percent or more at retirement age.
At this stage, Francis diversifies clients’ bond holdings within mutual bond funds, and individual bonds, including holdings in:
- Tax-free municipal bonds, to be put in clients’ taxable accounts.
- Taxable municipal bonds, which pay more and have a higher yield and are used for IRAs and other tax-deferred accounts.
- U.S. Treasury Inflation-Protected Securities (TIPS), for more conservative clients.
- International bonds, including those from developing and emerging markets, as a good portfolio diversifier.
- High-yield corporate bonds, which will have higher risk but higher yield.
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“We work toward an eventual shift towards higher weight in individual bonds because, compared to bond funds, they have lower cost and you always get the face value back at maturity,” Francis said.
White, from Life Certain, suggests several other options for diversification, including:
- Floating-rate bank loans, which are funds of bank loans typically tied to an index, such as LIBOR.
- Certain bond ETFs, such as those with one- or two-year maturities. “I like these because you know what’s in there,” he said.
- Unit investment trusts, which are portfolios of bonds with one maturity date.
—By Deborah Nason, special to CNBC.com