By: Dividend Sensei
Recently I explained how the 4% rule is often seen as the default retirement plan for many investors. This approach uses a 60%/40% mix of stocks and bonds and is based on a famous 1994 study that concluded that such a portfolio could generate enough inflation-adjusted total returns that allow one to comfortably live off during retirement — without fear of outliving their savings. However, this approach isn’t nearly as safe as many assume.
The issue here is “risk,” which is fresh on the minds of many investors due to the high stock market volatility. Specifically, I’d like to address the common-but-incorrect belief that Treasury bonds are “risk free” investments. Also, that we should allocate more of our portfolios to this asset class as we age.
A standard rule of thumb says that your portfolio amount that should be in stocks is 100 minus your age. Therefore, if you are 60 years old, that would mean you should own 40% stocks, and 60% low-risk bonds. The theory behind this is that bonds, especially Treasury bonds, are usually inversely correlated to stocks — meaning that if stocks fall, bonds will rise.
What many investors fail to take into account is that there are huge differences between an individual Treasury bond, and a bond fund or ETF, which is how the overwhelming majority of investors own this asset class.
It is true that any single treasury is indeed “risk free” because the US government is ensuring that you get your semi-annual coupon (interest) payment, and the principal at maturity. After all, the US has never defaulted on its debts, and the notion that US treasuries are 100% risk free is the cornerstone of the modern global economy. Pension funds, sovereign wealth funds, insurance companies, banks, and foreign governments all rely on the assurance that any Treasury they purchase will be repaid in full — no matter what. However, unless you actually purchase Treasury bonds individually, then you are actually exposed to far more risk than you may realize. Here’s why:
Imagine that the US government sells a $1,000 30-year Treasury bond with a 3% interest rate, when inflation is 1% and you buy it. You will now receive $15 every six months, for 30 years. And then your original $1,000 back. If inflation remains unchanged (and historically low at 1%) then your total return will be 3% minus 1% inflation, or 2%. Not a great return. BUT… it’s guaranteed that you will get your money back, and earn at least a positive return.
However, now imagine that inflation rises, due to stronger economic growth, and hits 3%. And some unforeseen financial situation forces you to need your $1,000 back. So you decide to sell your 30-year risk-free Treasury bond. To do so, requires selling it to a third party on the bond market. But, because inflation is much higher now, that 3% yield on the Treasury means that the total return would be zero (3% yield minus 3% inflation). So, no one would buy it.
That is because the US treasury is constantly issuing new bonds to finance the US deficit. And because the main determiner of Treasury yields is inflation expectations, if inflation is high, then treasury yields will rise. Let’s say that with bond market inflation now 2% higher, that very market (which determines the cost of US government borrowing) has 30-year yields at 5%.
With the US government now issuing new 30-year bonds at 5% yields, your 3%-yielding older bond is far less attractive — meaning that in order to actually sell it to anyone, you need to offer a discount, one that causes the $30-a-year interest payments to also yield 5% to any purchaser. In this case, that means $30/0.05 setting the value of your “risk free” bond at $600. Thus matching the new market price.
In reality, your bond would actually be worth slightly less, because it’s older and won’t generate a full 30 years of income as the new one would. But, the point is that if inflation were to rise (as it’s expected to due to stronger economic growth), then you could potentially lose a fortune, up to 40% on a supposedly risk-free investment. Of course this is only if you can’t hold on until maturity. If you have a long time horizon, (30 years), and can avoid being a forced seller (due to having a strong emergency fund), then you’ll be just fine.
Here’s where bond mutual funds or ETFs come in. These are what most investors use to get Treasury exposure. However, these funds own hundreds, if not thousands of treasuries, with various durations and maturing at different times. In other words, there is no fixed “final duration” at which point you are 100% guaranteed to get your principal back. In effect, a bond fund is a perpetual Treasury bond — one with a fluctuating-but-very-real duration, and thus inflation/interest rate risk.
If interest rates rise sharply, then these funds will fall significantly in value. That’s not a “maybe,” but a mathematical certainty, since bonds have literally no inflation protection (except for inflation-protected Treasuries or TIPs). Are risk-free treasury bond funds are 60% of your portfolio? Then guess what, you are going to be selling at a big loss — eroding your retirement income, and lowering your standard of living.
The only way to truly ensure you don’t lose money in bonds is if you can adopt a long-term time horizon, allowing you to ride out the economic cycle’s natural fluctuations, and time your exits. But, if the only way to not lose money in the long-term is to hold it for long periods (5+ years), then what good will that do for a retiree?
So in my next article I’ll explain a far better alternative to this kind “conservative,” and “low risk” investing. One that is actually far safer, more effective, and can actually fund a lifestyle that can make your golden years worthy of the name.