With the last-second fiscal cliff deal settling the question about dividend taxes, now’s a good time to revisit another retirement staple: bonds. It’s all the more timely because Goldman Sachs (NYSE:GS) said last week that investors playing in the bond market are “about to lose their shirts,” according to a report on CNBC. Scary stuff.
And GS isn’t the only one warning that the near 20-year run-up in bond prices is nearing an end. A survey by CNNMoney found 40% of the 32 investment strategists and money managers polled believe interest rates will rise in 2013, raising red flags for bondholders.
We all know the argument for bonds: Investment-grade bonds provide a steady stream of income to investors in the form of coupon payments, theoretically with little risk of credit default.
As interest rates have fallen over the past two decades, investors have flocked into bond funds looking primarily for safety from the turmoil of stocks. CNNMoney reports that, according to fund flow tracking firm EPFR, “individual investors have plowed nearly $210 billion in bond mutual funds and ETFs since the beginning of 2008, and in 2012 alone, investors added more than $90 billion to bonds, while pulling more than $150 billion from stocks.”
First question: Why the alarm bells at Goldman? Simple: Rising interest rates are the enemy of bond prices. Last week’s Fed meeting minutes indicated that not all the central bank governors are thrilled with the idea of an unending quantitative easing program. Just the mere possibility of ending the program sooner than anticipated sent the 10-year Treasury yield up to nearly 2% — its highest yield in over eight months.
Goldman and any other bond-market doomsayers are essentially saying the same thing: When this market reverts back to its mean — an historical average of around 6%, according to GS equity strategist Robert D. Boroujerdi — bondholders run the risk of getting creamed.
And make no mistake about it: The Fed is the biggest variable in this market right now as it continues buying long-term Treasuries and mortgage-backed securities from commercial banks and other institutions. That’s kept interest rates down and bond prices up.
But investors are also climbing into bonds — which continue to be a big part of retirement portfolios — because of stock market fears. Anyone who’s been burned by equity crashes over the past two decades is leery that the next one might wipe out years of investment patience. If you’re retired now or will be within the next 5 to 10 years, could you weather another meltdown?
Investors are also seeing the same thing the Fed sees: low employment and a slow economic recovery. The Fed is limited both financially and politically in ways to pump inflationary money into the system any time soon. The result? Inflation-adjusted real interest rates are still favorable, at least for the short term (two to three years).
So, what should we do? Goldman wants investors to look toward equities, particularly dividend stocks. And why not? Buying into dividend-paying stalwarts like Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ) and Proctor & Gamble (NYSE:PG), just to name a few, provides steady income and dividend yields that are well north of the 10-year Treasury’s current 1.9%. Plus, you have the chance to gain in stock price appreciation.
Others suggest looking at shifting to bonds with shorter maturities. Yields — and risks — are far higher the longer out you go. Perhaps taking some profits out of of those 30-year bonds and swapping into 5- or 10-year maturities is a good idea. I certainly don’t advocate jumping out of bonds all at once and forever.
Also, how about moving into highly rated corporate debt?
IBM (NYSE:IBM), Exxon Mobil (NYSE:XOM) and Microsoft (NASDAQ:MSFT) all offer bonds at yields exceeding Treasuries, and all come with some pretty solid credit ratings. Alternatively, you can put some of that money into Fidelity Corporate Bond Fund (MUTF:FCBFX), which invests up to 80% of its assets in an assortment of investment-grade corporate bonds.
Ultimately, the decision is up to you (with a little advice from a trusted adviser). But don’t necessarily be cowed into action by one call from a firm that, after all, makes a lot of money selling securities. Bonds are an important part of every portfolio for safety, liquidity and income. Just make sure you’re in the right bond category for your situation.
Marc Bastow is an Assistant Editor at InvestorPlace.com. As of this writing he is long MSFT, XOM, and JNJ.