With interest rates so low, it’s getting harder and harder to find income for clients. The five-year Treasury bond is yielding a mere 1.39%, while the iShares Aggregate Bond Fund (AGG) is yielding only 2.39% as of Sept. 30, 2013.
It’s both tempting and easy to put our clients in bond and bond funds yielding much more. Intermediate-term investment grade bonds are yielding about 3% while long-term investment grade bonds now yield nearly 5%. High yield debt is paying more and emerging market debt is paying 8%.
In fact, some advisors are abandoning bonds and now using bond substitutes such as dividend stocks, preferred shares or master limited partnerships (MLPs).
But consider what happened to all of these investments only five years ago. In 2008, the U.S. stock market fell 37% and the role of the bond portfolio was to act as a shock-absorber. iShares’ AGG did just that, increasing by 7.57% that year. Yet, according to Morningstar, the average bond fund declined by about 8% that year. In nearly all bond funds, the higher credit risk resulted in higher losses. And the so-called bond substitutes fared far worse.
If you or your clients think 2008 can’t happen again, you may be right. Whatever causes the next stock market plunge will probably be very different. But regardless of what causes it, the higher risk bonds and bond substitutes are nearly certain to get creamed as well.
When clients demand income, remind them that their quest for income could ultimately lead them to run out of money to live on. Remind them that money is stored energy that allows them to do what they want with their lives and they can’t take it with them when they pass away. This means they can also spend down the principal rather than live on the income alone.
The U.S. government has issued roughly 70% of taxable investment grade bonds. It may be a good idea to make sure our clients have a large part of their fixed income portfolio in U.S. issued bonds as well.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct instructor at the University of Denver.