By most objective measures, now is a terrible time to own bonds. Short-term interest rates are near 0%, and even 30-year Treasuries pay around 3% interest. Because of the way bonds react to interest rate changes, a 30-year Treasury bond could fall around 20% in market price from a one-percentage-point increase in interest rates. With interest rates expected to rise in the not-too-distant future, it might even seem crazy to be anywhere near bonds at the moment.
Despite those risks, if you're retired or expect to retire in the near future, you really should own bonds as part of your retirement portfolio. Because of low current interest rates and likelihood of higher rates to come, however, not just any bond will do. Instead, you should focus the bond part of your portfolio on the very specific benefits that bonds can bring you that stocks cannot.
What bonds do better than stocks
Bonds have two key characteristics that earn them a space in a retiree's portfolio, even in today's low-interest-rate environment. First, they have a higher certainty of payment than stocks do. Companies can and do cut their dividends if they feel sufficient financial pinch, with no risk other than to their stock prices and reputations.
A company's bond is higher up on the corporate capital priority scale, however, and failure to make a promised bond payment leads to default. When a company defaults on its bond payments, its creditors can typically force it into bankruptcy and potentially either take control of its operations or liquidate its assets to help cover the otherwise missing money. That threat of default and loss of control or assets makes it very likely that if a company can pay its bonds as scheduled, it will pay its bonds as scheduled.
The second key characteristic that bonds have that earn them a space in a retiree's portfolio is that they mature. On that maturity date, the issuer must pay exactly the face value of that bond to whoever holds the bond -- or else face that same risk of default. Companies typically either pay off their bonds with cash they've accumulated from their operations or they roll over their bonds by issuing new ones and using the proceeds to pay off the maturing ones.
Ladder up to use bonds successfully today
That combination of a high likelihood of payment and a known expected value on a known date provides the one-two punch that earns bonds a place in your retirement portfolio. Still, in today's low-interest-rate environment where rates are expected to rise, not just any bonds will do. The way to use bonds successfully in today's environment is to take advantage of that known payment and maturity schedule to create something known as a bond ladder.
A bond ladder is a collection of bonds with maturity dates that move progressively further out. When you set one up for your retirement, the goal is to be able to use the cash generated by the maturing bonds to help cover your costs of living. Since you're looking for these bonds to provide your retirement cash flow, you'll want to stick with either Treasury bonds or diversify among high-quality, investment-grade corporate bonds.
From a basic design perspective, assume you're expecting $3,000 per month in living expenses and taxes in retirement and are anticipating receiving $1,300 per month in Social Security. In that situation, you'd set up a bond ladder so that you'd initially have around $1,700 per month of bonds maturing. For the sake of keeping complexity or commissions down, though, you might actually set that up where you've initially got $5,100 per quarter, or $10,200 every six months, in maturing bonds.
When setting up your bond ladder, include a reasonable estimate for inflation for the future years, so that you have a decent chance of preserving your purchasing power from those maturing bonds. You'll initially want your bond ladder to last somewhere between seven and 10 years, though that number may flex both up and down a bit as you work your way through retirement. The rest of your retirement portfolio can remain invested in stocks, for their greater long-term growth potential.
The seven-year minimum is important because you don't want to have to rely on selling stocks to cover your basic living expenses. Money you need to spend within the next five or so years does not belong in stocks. By starting with at least a seven-year ladder, you have two additional years of cushion to draw down your ladder without getting below that five-year limit if the stock market doesn't cooperate in the short term.
How to maintain your bond ladder throughout retirement
Once you've set up your bond ladder, you spend the cash from your maturing bonds to cover your costs of living. As time passes, your existing bonds all get closer to their maturity date, and your bond ladder shrinks in length as a result. To help assure your bond ladder lasts as long as your retirement, though, you'll need to keep replenishing it by buying bonds that mature farther out in time.
You'll have three sources of cash to buy those bonds. First, the existing bonds you own will probably be paying interest, which can be reinvested in other, longer-term bonds. Second, your stocks may pay dividends, which can also provide you with a source of cash to reinvest in those bonds. Third, you'll have the stock portion of your portfolio, from which you can sell off a bit to extend that bond ladder.
Unfortunately, you can't guarantee that the market will cooperate and give you higher stock prices to let you reliably sell off shares as that third source of cash to keep extending your bond ladder. That's why you start off with at least a seven-year bond ladder -- so that if the market has a down year or two, you don't have to sell your stocks in a down market to cover your immediate costs of living.
In a normal year in the stock market, you can use some of your stock gains to replenish the longer-term end of your bond ladder. In a really good year in the stock market, you can even extend the length of that ladder further. When the market doesn't cooperate, you won't be forced to immediately sell to cover your costs of living. You'll just let the bond ladder shrink a bit and wait for a market recovery.
You'll still have the bond interest and stock dividends to help support the bond ladder, but particularly in today's low-interest-rate environment, that may not be enough to fully replenish the out years. Still, by setting up the bond ladder in the first place, you're giving yourself the ability to wait out a fairly prolonged market correction without having to sell your stocks at a low price just to cover your bills.
Bonds can still help retirees -- even today
In a time of low interest rates that are expected to rise, bonds can be an incredibly scary investment. Still, by creating a bond ladder and looking for the maturing bonds to provide cash flow to cover your costs of living, you can put them to productive use in your retirement, even today. Just be sure to invest in bonds with that goal in mind, and you'll improve your chances of successfully using them as a key part of your retirement funding plan.
Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.