Today, I’d like to CONTINUE OUR SERIES on the topic of “Retirement and Falling Interest Rates?”, specifically focusing on what to avoid.
First, AVOID reaching for yield: Over the past few years, investors have enjoyed putting their cash in money market funds and collecting attractive yields with virtually no risk. However, as rates come down, these risk-free rates will also fall. While searching for higher yielding investments, investors may subject their money to volatility and possibly the loss of principal.
Focusing on the yield of an investment at the expense of all other due diligence will have an unfortunate ripple effect on the rest of one’s finances. Money that folks need for near-term expenses or a rainy-day fund should still sit in cash or cash equivalents despite a more modest yield.
Next, AVOID pursuing lower quality credit: Investors may be enticed by lower quality credit to maintain a certain yield within their fixed-income allocation. Unfortunately, that means investing in companies with shakier balance sheets. This may be fine for a small portion of one’s portfolio. However, substituting most of your fixed income to obtain a higher yield is ill-advised.
As I frequently remind my clients, risk and return are inextricably linked. If you want higher yields in a low-interest-rate environment, you need to be willing to take more risk with your capital. It’s important to keep in mind that the ultimate role of high-quality bonds in one’s portfolio is to serve as a ballast against more volatile equity positions. Once you invest in lower quality companies, those diversification benefits, and the margin of safety, are gone.
You should also AVOID extending duration: Another way for investors to maintain a targeted yield within their portfolios is by extending the duration on their fixed-income holdings. In other words, instead of going out one or two years on the yield curve, they instead go out one to two decades or longer.
The challenge is that duration is a measure of a bond’s price sensitivity to interest-rate changes, expressed in years. Therefore, a bond with a higher duration is more sensitive to interest-rate fluctuations. Its price will change more significantly for a given change in interest rates than the price of a lower duration bond. For example, a bond with a 10-year duration is expected to lose approximately 10% of its value if interest rates rise by 1%, whereas a short-duration bond would be expected to lose only about 1% of its value.
Any unexpected change to interest-rate policy can leave bond investments just as volatile as equities. Extending duration on your bonds leads to more portfolio volatility without the upside that equities provide.