Given the one-two punch of a soaring stock market and minimal interest rates, bonds are producing a far smaller return on average than stocks, prompting many retirees to keep larger and larger percentages of their portfolios in stocks. But shunning bonds increases a portfolio's risk significantly -- and high risk is the last thing any retiree wants.
Bonds and interest rates
A bond is essentially a promissory note: you lend your money to a company, government agency, or other entity, and the borrower agrees to pay you a certain rate of interest for the use of your money. Thus, low interest rates overall means minuscule bond returns. Worse, when rates do rise, the bonds you already hold will decline in value. After all, why would anyone want to buy your treasury bond paying 2% interest if they can buy a shiny-new one from the government paying 3% interest? If you do sell such a bond before it matures, it will be at a substantial discount; but if you hang onto it, you'll be losing out on all the extra interest you could have been getting on a new issue.
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Bond stability
Nevertheless, bonds are far more stable than stocks. In a brutal bond market, you do have the option of hanging onto your bond until it matures, in which case you'll get the whole of your principal back.
Stocks come with no such guarantee: if you buy a stock at $50 a share, there's no rule saying that hanging onto it for, say, 10 years guarantees that you can then sell it for $50 a share. If you're lucky, in 10 years the stock will be worth far more than $50 per share, but if you're unlucky, you may end up unloading it for $10 or $20 per share... or even less. And while it is possible for bond issuers to default on their bonds, if you stick with federal government bonds, the risk of default is essentially zero. No such guarantee exists with stocks, although large, healthy, well established companies are unlikely to disintegrate so badly that their stocks become worthless.
Steady income
Bond interest payments are guaranteed at the rate set by the issuer. So if you have bonds in your retirement portfolio, you know exactly how much those bonds are going to pay you year after year. Stocks do provide income in the form of dividends, but dividends are very much not guaranteed. Even preferred stock doesn't offer a sure dividend, because the company isn't required to issue the dividend on its preferred stock if it also skips the dividend on its common stock (if the company later recovers, it does have to make up the preferred dividend payments it missed). So dividends can zig and zag quite a lot, especially over the short-term. That can be a real problem for a retiree counting on those dividends as a major source of income.
Tax potential
Some bonds' interest payments are not taxable, which can result in considerable savings if you are in a high tax bracket. In brief, interest from bonds issued by the federal government is taxable as income for your federal taxes but exempt from state and local taxes; municipal bonds' interest payments are always exempt from federal taxes and will be exempt from state taxes if you live in the state that issued the bond. Dividends, on the other hand, are always taxable, as are interest payments from corporate bonds. The only option for completely avoiding taxes on dividends (and interest from corporate bonds) is by keeping the securities in a Roth account. In an ordinary tax-deferred retirement account, dividends and interest won't be taxed when they come in, but will be taxed as income when you take them out of the account.
Get better bond returns
Since we can't control interest rates, we can't control bond returns -- but we can take steps to shift the odds in our favor. If interest rates are low but climbing, inflation-protected bonds are an excellent investment. These bonds interest payments will go up as rates rise, unlike standard fixed-interest bonds. Putting together a bond ladder also reduces your risk by ensuring that your principal isn't all tied up at once. And while individual junk bonds are a terrible investment for retirees, putting a small percentage of one's bond money into a junk bond ETF is a relatively low-risk way to enjoy the higher returns on such bonds. Remember, safety and stability are far more important for retirees than for workers, because if your portfolio falls apart, so does your income.
