From their double-digit highs in the 1980s, interest rates have been on a long and steady decline, reaching historic lows the last couple of years. This has been great news for anyone purchasing a home or taking out a loan, but especially for investors holding bonds. This is because bond values have an inverse relationship with interest rates; so, when interest rates are low, bond prices rise. But thanks primarily to the recent surge in inflation, which is forcing interest rates to rise, that forty-year bond rally has come to an end.
For decades, the conventional wisdom has dictated that investors add bonds to diversify their portfolios and balance out more volatile equity investments. For many investors, high-quality bonds have been the backbone of their portfolios due to their reliable yields and downside protection. Until now, this has been reliable advice because bonds and stocks are uncorrelated. In other words, when stock prices decline, bond prices tend to increase, and a combination of the two investment types would reduce portfolio volatility and risk, especially for those nearing retirement.
The Tide is Turning on Bonds
However, the prospect of higher interest rates makes it difficult for bonds to carry their role as a defensive hedge. With bonds yielding less than the inflation rate, we can see investors abandon high-quality bonds for higher-yielding bonds, further driving down bond values.
With inflation-adjusted yields on bonds going negative, they can produce a drag on portfolios. And with nowhere to go but down for bond prices, investors holding Treasuries or high-grade corporate bonds put themselves at a guaranteed risk of loss. So, the question for investors, especially those in or near retirement who have come to rely on bonds to balance out their equity portfolios, is where to go from here. What are some risk-averse alternatives to use in a retirement portfolio today?
Inflation Risk has Increased for Retirees
But before we can answer that question, we can’t forget how inflation factors into this picture, as well.
Yes, investors in retirement have always had to factor in inflation when planning their cash flow. Even at 3%, which inflation has averaged over the last ten years, a retiree’s purchasing power would be cut in half in 24 years. At a 5% average inflation rate, it would take just 14 years. At 7% average inflation, it would take just over ten years. So what happens when inflation stays higher for longer?
No one can say for sure how long this higher inflation will last, but even if a higher percentage is here for a couple of years, it presents a more challenging hill for retirees to climb. To overcome the loss of purchasing power, retirees will need to rely more on the growth portion of their portfolio, which may require expanding their allocation to equities. Contrary to popular belief, though, this doesn’t have to be a scary thing. Equities, after all, have proven to be one of the most effective ways to overcome inflation.
At the End of the Day, Retirees Need to Embrace Total Returns
For many investors, understanding how to handle all of these risks in retirement really comes down to a shift in mindset. To position themselves for an extended period of rising prices and rates, retirement investors should change their mindset from that of depending on high yields to that of relying on total returns. Rather than chasing only capital appreciation, investors should look at both capital appreciation and yields, specifically yields on dividend-paying stocks.
You see, the performance of stocks during an inflationary environment tends to be mixed. Generally, capital-intensive companies with high debt and low profit margins tend to struggle when inflation rises. High-quality, well-managed companies tend not to be capital-intensive. They typically have low or no debt, higher gross margins, and increasing return on invested capital (ROIC), enabling them to perform well during high inflation periods. High-quality companies with strong brands and competitive advantages also have pricing power, which allows them to increase their prices with little or no impact on demand. Therefore, as consumer prices rise, so too do their revenues.
Many of these high-quality companies also pay dividends, which is one way they return profits to their shareholders. Some of the best companies have a long history of paying and increasing dividends, many with yields far more than the current yields on bonds. So the total return on these investments limits overall risk. Investors who can hold high-quality stocks through at least a couple of market cycles are often rewarded with positive returns. And during periods of declining market prices, the dividends can serve as the ballast investors once sought from bonds.
Adding Layers of Protection to Your Portfolio
If your investment portfolio is already well-structured, you should be well-positioned to capture appropriate measures of expected investment premiums over time, while defending against inflation and other risk/reward tradeoffs. But, if you haven’t taken a look at your allocation lately, and have a higher exposure to bonds, it may be time for some realignment since the current state of bonds could be more of a drag on your portfolio.
Overcoming and Hedging Against Inflation
To overcome the impact of inflation on your lifetime income sufficiency right now will require greater exposure to equities. A well-constructed equity portfolio consisting of high-quality stocks and a reliable stream of dividends can work to generate solid total returns without the volatility of the overall market.
Another way to preserve the spending power of your upcoming portfolio-generated cash flow in retirement is to allocate some of your fixed income to assets that move in tandem with inflation, such as Treasury Inflation-Protected Securities (TIPS) as opposed to “regular” Treasury bonds.
Your Portfolio Should Be Customized to You. Every Time. Without Exception.
As you may be able to tell by now, different investments perform differently in different environments. Yes, that’s a lot of the word “different” and for good reason. The most important thing to keep in mind in retirement is that changing market conditions will affect the way you position your portfolio to generate the predictable income you need to maintain or enhance your lifestyle.
The second most important thing to remember is that there is no blanket approach that works the same for every couple, individual, or business owner we help. The right choice for you may not be the right choice for our next client. Of course, we use the investment principles like those described above to guide our decision-making, but that doesn’t mean that your portfolio should be structured the same way as everyone else’s.
This is precisely why all of our portfolios are custom built with your needs and goals in mind, every time, without exception. This means that we are constantly looking at the market conditions and measuring them up against your timeline and risk profile to make sure your needs are continuously met.
Our goals at WillKate run deeper than generating returns. Our mission is to get to the heart of the life you’re looking to build and make your investment management decisions with those big picture considerations in mind.
If you’d like to learn more about this unique approach to financial planning and wealth management (and why our clients love it so much), we’d love to meet you. We serve clients locally in Sioux Falls and Aberdeen, South Dakota and throughout the country. Wherever you are, we can help. Click here to schedule your Free Intro Call with us today.