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Bonds take on a bigger role in retirement, as investors take chips off the table to protect their nest egg.
Unfortunately, it’s easy to get tripped up — namely, by chasing returns and taking too much risk, according to financial advisors.
“Bonds are the single biggest mistake I see over and over and over again,” according to Allan Roth, a certified financial planner and accountant at Wealth Logic, based in Colorado Springs, Colorado.
“Bonds should be boring … and allow you to sleep at night,” he said.
Stocks are the growth engine of a retiree’s portfolio, as they were during their working years. They help a portfolio keep pace with the cost of living, which may be substantial over a retirement of maybe 30 or more years.
But it’s generally too risky for retirees to put all their money in stocks.
Perhaps half or more of their nest egg (depending on the investor) will likely be in bonds or bond funds, which serve as a general shock absorber when stocks tank; retirees may also use bonds as a source of cash to live on or to rebalance their portfolios when stocks fall, according to advisors.
“The main reason you hold bonds is to stabilize your portfolio,” Christine Benz, the director of personal finance at Morningstar, said.
This doesn’t mean bonds are immune from losing money. In fact, 2021 was a rare year in which U.S. government bonds lost money. But bonds generally hold their ground or yield a slight gain when stocks fall, Benz said.
Which bonds to choose?
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However, some bonds and bond funds are safer than others.
Retirees should aim to hold only high-quality bonds, advisors said. That means generally avoiding “junk” bonds and choosing those of investment-grade caliber, advisors said.
That’s because junk bonds often move in tandem with stocks. They’re issued by companies or governments at higher risk of defaulting on their debt — and incapable of repaying investors — during a recession or if the stock market tumbles, advisors said.
(They’re often called “high yield” bonds because the issuer pays a higher return to compensate for that higher risk.)
Retirees who want exposure to junks bonds should use money earmarked for stocks and not bonds, Benz said.
One general approach to bond investing is to allocate a third of the bond portfolio to each of three categories: U.S. Treasury bonds, corporate bonds and mortgage-backed securities, according to Charles Fitzgerald, CFP and principal at Moisand Fitzgerald Tamayo.
(Allocating to municipal bonds may also make sense, especially for high-income retirees with a taxable brokerage account, given their tax advantages, Fitzgerald said.)
Retirees should buy investment-grade bonds, which are issued by entities with a high credit rating, Fitzgerald said. For example, Standard & Poor’s investment-grade ratings include AAA, AA, A, and BBB.
Aside from bond type and credit quality, retirees should also consider “duration” when buying a bond fund, Fitzgerald said. This measures the average time it will take for the fund’s bond holdings to mature (i.e., come due).
Given recent high inflation, it makes most sense to buy funds that are short-term (0 to 3 years) or intermediate-term (about 3 to 7 years), Fitzgerald said.
“Inflation can just destroy the money-making ability of a long-term bond,” Fitzgerald said.
A simple approach
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However, there’s a simpler approach for retirees who are less do-it-yourself oriented.
For one, they can buy a mutual fund or exchange-traded fund that tracks a broad, diversified bond benchmark, Roth said.
The Vanguard Total Bond Market Index Fund (VBTLX or BND) and iShares Core U.S. Aggregate Bond ETF (AGG) are the two most common he uses with clients.
“It shouldn’t be complicated,” Roth said of retirees’ approach to bonds.
They may also invest their nest egg in a low-cost “balanced fund,” Fitzgerald said.
These funds are a one-stop shop that diversify across both stocks and bonds according to a pre-set allocation. (A retiree who wants a 50-50 stock-bond split would invest in a 50-50 balanced fund, which automatically rebalances holdings for investors.)
Target-date funds are similar; they pick a mix of stocks and bonds depending on an investor’s envisioned retirement year. They generally change their asset allocation over time, becoming more conservative. Retirees should make sure the fund doesn’t throttle back on stocks too much or deviate from their desired asset allocation throughout retirement if they use this approach.