- 4-Minute Article
- Feb 24, 2020
Retirement Planning Fundamentals: The Role of Fixed-Income Investments
A look at the traditional benefits of bonds and bond funds and the potential impact of changing market conditions.
Fixed-income investments such as bonds and bond funds traditionally have worked alongside stock investments—also called equities—to form the foundation of retirement investment plans. The two asset classes complement each other because they each have key differences in their risk characteristics and potential returns.
To use fixed-income investments appropriately, it’s critical to understand how bonds work and recognize the roles they typically play in a retirement strategy. It’s also important to work with a financial professional who can examine the current market environment and help develop a strategy that balances fixed-income investments with other asset classes and investment products to help meet your retirement planning needs.
Generally speaking, bonds are like an IOU between an investor and the entity that issues the bond—typically a government, government agency, or company. When someone purchases a bond, they are loaning money to the bond issuer for a set period of time. The bond issuer promises to repay the loan amount by the end of that period and, in the interim, the issuer agrees to make regular interest payments.
Those regular interest payments, plus the promise of repayment, can make bonds less risky than stocks. One of the biggest threats with bonds is “default risk,” the risk that the issuer may fail to make interest payments or fail to repay the loan. However, bonds with a relatively low default risk can be purchased from stable issuers such as the U.S. Treasury.
The tradeoff for lower relative default risk is that bonds typically provide lower potential returns than stocks. While past performance doesn’t guarantee future results, long-term data helps illustrate the point. Since 1928, the average annualized return of the S&P 500® IndexA has been 9.5%, nearly double the 4.8% average annualized return of 10-year Treasury bonds.1
Because of bonds’ characteristics, two of their traditional uses in a retirement plan are:
- Diversification. Bonds are generally less volatile than stocks. They also tend to react differently than stocks to various economic factors. For these reasons, including bonds in a diversified portfolio can help reduce the portfolio’s overall volatility. For example, during the financial crisis of 2008 when stocks suffered losses of -54.9%, bonds provided positive returns of 7.2% as measured by the Bloomberg Barclays U.S. Aggregate Bond Index.
- Generating income. Because bonds can pay a reliable stream of income in the form of regular interest payments, many retirees traditionally hold individual bonds or bond funds to help cover their retirement expenses.
Because the basic characteristics of bonds haven’t changed, their diversification potential is still strong. A financial professional can help develop the right mix of bonds and other asset classes for your needs. For example, people approaching retirement have less time to let their savings recover from market downturns and may want more balance between stocks and bonds than a person with more time to focus on maximizing growth potential.
The income-generating potential of bonds can be affected by changing market conditions, which means returns may be lower today than in the past. In 2019, yields on the 10-year U.S. Treasury and the 30-year U.S. Treasury were near historic lows. Going forward, it’s likely that bond returns will remain low; research shows that the current yield of bonds is a good predictor of long-term returns. (Source: Bloomberg)
Faced with these low interest rates, income-oriented investors might feel pressured to invest in higher-yielding bonds. During periods of increased market volatility, these often come with higher risk and greater potential for losses than more stable U.S. Treasuries.
To help develop a strategy that makes the most of bonds’ potential benefits, work with a financial professional to help review your retirement goals. If a bond allocation alone looks like it might not provide enough income, you might consider expanding your income strategy to include other potential income-generating products such as annuities.
Certain annuities may generate more income than some bonds while also offering optional benefits such as a guaranteed lifetime income.2 Different types of annuities can also fit different goals. For example, deferred annuities let owners choose a future date on which to receive income payments.
Additionally, variable or indexed annuities offer growth opportunities that may translate into higher future income payments. Index-linked annuities may also provide a measure of protection against market downturns.3
Properly diversifying a portfolio with some fixed-income investments while also looking for options that can provide additional income where needed can help you feel more confident about meeting your retirement goals.
For more ideas on how to diversify your portfolio, visit brighthousefinancial.com.