Stock investors have had little to complain about for the past several months. But if you're a retiree with a big part of your money in fixed-income investments like bonds, you might be quaking in your boots right now -- and with good reason.
At the first sign of trouble in stocks, you'll hear about it from just about every source imaginable. But when other types of investments, such as the bond market, suffer large declines, you can't expect to hear about it from mainstream news sources. Yet for many investors, and especially those who are already retired and relying on investments they see as low-risk and safe, the recent declines in bonds are potentially much more troublesome.
What's happening
To understand the magnitude of the move in bonds, consider these data points:
- Yields on the 10-year Treasury have moved up close to a full percentage point in just over two months, rising to around 3.3% as of Friday.
- The 30-year Treasury hasn't seen as big of a yield rise. But because 30-year bonds are more sensitive to interest rate changes, their value has fallen much more precipitously.
- Investors who rely on exchange-traded funds for their bond exposure have seen big losses as a result. ETFs that focus on Treasuries have been hardest hit, but even broad bond market ETFs Vanguard Total Bond Market ETF (NYSE: BND) and iShares Barclays Aggregate Bond ETF (NYSE: AGG) have fallen 2.5% since early October. That may not sound like much, but given the low yields on bonds lately, that represents nearly nine months' worth of income distributions.
- Tax-free municipal bonds, which many retirees seek out as a way to minimize tax liability, have done even worse lately. The SPDR Nuveen Barclays Municipal Bond ETF (NYSE: TFI) has fallen 5.5% in two months, as higher interest rates combine with a supply overhang and concerns about the health of state and local government balance sheets.
Yet even after all this, no one can fairly say that rates are particularly high. Although we've stopped setting multidecade records for low yields, the Federal Reserve remains committed to keeping short-term interest rates low -- and through its latest quantitative easing program is also trying to keep long rates from rising as well.
How retirees should respond
Despite the Fed's efforts, though, retirees with a conservative investing mentality should be anxious about keeping too much of their money in long-term bonds right now. Buying long bonds may seem like the only way to earn a decent return on your money, as short-term rates are still well below 1% right now. But what short-term investments give you is security -- security that you won't suffer big losses if interest rates continue to rise. And if you're on a fixed budget, you simply can't afford to take those losses, even if it means giving up a little extra income in the short run.
But if long-term bonds aren't the answer for retirees, what is? I'd advise a prudent mix of two investments: cash and dividend-paying stocks. On the cash side, you can find savings accounts paying more than 1%, where you can hold the money you'll need in the next few years without worrying about interest-rate risk. In addition, after rates do rise, having cash on the sidelines will let you lock in those higher rates in CDs or Treasuries without having suffered capital losses by getting in too early.
Dividend stocks are another great option, but don't just pick any dividend stock. For instance, CenturyLink (NYSE: CTL) and Windstream (Nasdaq: WIN) pay great dividends, but the companies have few growth prospects. That makes investors more likely to price the stock as if it were a bond -- and as prevailing interest rates rise, investors will put a lower value on bond-like stocks.
In contrast, growth-oriented dividend stocks aren't as rate-sensitive. Coca-Cola and Chevron aren't super-growth prospects, but they aren't stagnant businesses and have opportunities to expand around the world. As investors move away from bonds, these and other blue-chip dividend payers will get the lion's share of their attention. That's a move worth making now to get a jump on the crowd.
Be smart
A collapsing bond market is bad news for many retirees. But if you have the foresight to make a smart move before the real damage begins, you just might end up better off.
Whether you're already retired or still working hard, you can't afford any mistakes with your retirement money. Click here to read the Fool's new special report, The 7 Secrets to Salvage Your Retirement Today.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.
