By The Retirement Income Store
The stock market, earnings, and even interest rates … many economic indicators have been rising since the start of the year. Is that good news for your retirement plan? Well, it depends.
I sometimes describe investing for income as a strategy that works regardless of stock market conditions. However, it can sometimes work even better due to market conditions. All the recent market mania gives us a great opportunity to explain just how and why that is.
The Battle Between Bonds And Rising Interest Rates
When investing in bonds and bond-like instruments, interest rates are the key factor in many ways. But there are a lot of misconceptions about interest rates and how they affect those who invest for income. One of the earliest financial lessons you probably learned is how interest rates help your money work for you. As a kid, you learned that when you put your money in a retirement savings account at the bank and leave it there, it earns interest and grows. It was a pretty exciting concept considering that back in the 60s and 70s, the average personal retirement savings rate ranged between 7.5 and 8.5%, far different than today’s low-interest-rate environment.
How Does The Bond Market Affect Your Retirement If You’re Investing For Income?
Bank and money market interest rates have been under 2% for over a decade and are currently below 1%. That means if you have money in a retirement savings account or even a bank CD, once you factor in the 3% average annual inflation rate, the spending power of that money is shrinking. The bottom line is that banks are pretty much out as an option for putting your money to work for you with interest rates. When you’re in or nearing retirement, you need your money to work for you. Specifically, you need it working to generate a competitive rate of income. That’s where bonds and bond-like instruments come into play.
The Bond Market
When you’re invested in individual bonds and bond-like instruments that make up a typical income portfolio, you’re earning income at an interest rate that’s much higher than any bank can offer—typically between 3 and 5%. That’s just one benefit of investing for income where interest rates are concerned.
As you know, corporate earnings and interest rates go up and down all the time. As a result, stock values, bond values, and the financial markets, in general, are always in flux. That’s what makes the idea of putting your money to work for you simple in theory, but not so simple in practice. Here’s how that applies to income: with an income strategy, it’s true that rising interest rates create what we call a headwind for your investments. Falling interest rates create a tailwind.
The Inverse Relationship Between Interest Rates And Bond Values
There’s a well-known rule that when interest rates rise, bond values fall and vice-versa. Unfortunately, it’s not that simple for several reasons, the most important being that when you invest in bonds and bond-like instruments you’re investing by contract. Typically, that contract guarantees two things: income return at a fixed rate of interest for the life of the bond and a return of your principal at maturity (assuming there have been no defaults).
That means if your contract says you’ll get income at 3.5%, you’ll get it at 3.5% regardless of whether rates start to rise or fall. But what about the actual value of your bond? That’s where the headwind comes in.
Since rising rates will cause the value of your individual bonds and bond-like instruments to drop, you’ll see that loss reflected in your monthly financial statement. By the same token, when rates fall you may see your values increase. These changes might affect your mood, but they do NOT affect how your money is working for you. That’s because of your contract.
Your bond value might fluctuate on paper due to an interest rate headwind or tailwind, but it has a par value that can’t fluctuate and doesn’t change – which is how you know you’ll get the par value of that investment back when the bond matures. By contrast, common stocks have no par value and no contract, which means any loss in value may never be recaptured as they never mature.
So, we’ve discussed how income strategies can help protect your money from interest rate headwinds, but what about a consistent headwind? I believe we’ll be in an overall low-interest rate environment for a long time to come. With that said, it’s also important to understand that the trend of overall declining interest rates is over.
For about 40 years starting in the 1980s, bond investors mostly had a tailwind. You could simply buy a bond and hold onto it, knowing its price was more likely to go up. But this long-term trend of declining rates eventually bottomed out, making things more challenging for income investors. This is where the active management of income-generating investments is the key to meeting this challenge. Here’s why.
Financial market indicators are always in flux, and that includes interest rates. What’s more, they constantly experience minor ups and downs within their broader directional changes.
You see it in the stock market all the time: big, dramatic intra-day point swings. If you’re a buy-and-hold stock investor, those swings don’t mean much in the big picture. However, if you’re a day-trader, they can be very meaningful. It’s similar when it comes to an actively managed portfolio of individual bonds and bond-like instruments.
A financial advisor who specializes in the active management of individual income-generating investments can continually take advantage of minor fluctuations in the bond market to upgrade your portfolio for higher yields and capital gains opportunities. That means active management not only allows you to help protect your portfolio from potential losses in a rising interest rate environment, but it also gives you some upside potential to increase your income return.
Even better, any loss you do incur from an interest rate headwind is typically only a temporary paper loss. That’s because you have a contract that guarantees your principal will be returned when your bond matures (assuming no defaults) regardless of any headwind. In the meantime, it’s generating income at that fixed rate, which you can use to meet your income needs or reinvest strategically to grow your portfolio the old-fashioned way.
Will Inflation Be Permanent In The Long Term?
As we mentioned, inflation can be a bad thing for savers who have their money sitting in a bank savings account, as inflation can erode the purchasing power of their retirement savings. Today, the inflation data, with all manner of things from lumber to sugar to copper surging to multi-year or all-time highs, it’s clear that the rate of inflation is running many multiples higher than the Fed’s official 2% target.
There are some economists who attribute the recent rise in prices to all the pent-up consumer demand that resulted from the COVID-19 shutdowns. These economists believe that the rise in prices can be attributed to the large number of consumers going out and spending on things they may not have been able to during the shutdown. If this is the case, then the rise in inflation could level off as this temporary bump in spending passes. Other economists believe that the tremendous amount of money that has been pumped into the economy as a result of the COVID-19 relief efforts could result in ongoing inflation. Only time will tell which group is correct.
Do Record Levels Of Debt Become An Issue?
Federal Reserve Chair Jerome Powell was recently quoted by Markets Insider as saying that “The US federal budget is on an unsustainable path, meaning simply that the debt is growing meaningfully faster than the economy.” In regard to the record levels of debt, Powell added that “The current level of debt is very sustainable. And there’s no question of our ability to service and issue that debt for the foreseeable future.” Powell also stated that the U. S. Government will need to return its debt to a more sustainable level once the economy has stabilized.
Will Rates Be Increased By The Fed Or Will They Go Up Organically Because Of Consumer Demand?
As you may know, short-term interest rates are set by the Federal Reserve. Long-term rates are determined by market forces, including activity in the bond market. A simple way to look at it is that when interest rates rise, it’s generally seen as a sign bond buyers are optimistic about the economy. When interest rates fall or stay flat, it’s read as a sign of economic pessimism.
However, that’s not the whole story; it’s much more complicated. From 2000 to late 2007, long-term interest rates as measured by the yield on the 10-Year US Treasury hovered between 4 and 5%. Since then, they’ve only risen above 3% a few times. What happened?
Well, what happened was the financial crisis and the Great Recession – or, more accurately, the Fed’s response to it. The Federal Reserve launched unprecedented levels of quantitative easing, which involves buying up trillions of dollars in US treasuries. Ultimately, this works to artificially manipulate long-term interest rates. It keeps them lower than they might be under normal circumstances.
How Could The Money Supply Starting To Contract Or The Fed Starting To Taper Affect The Markets?
In the financial world, the word taper is used to describe the reduction or winding down of quantitative easing efforts by the Federal Reserve. The Fed supposedly began tapering off quantitative easing in 2013. That’s when Ben Bernanke, who was Fed Chair at the time, announced that the Fed might reduce the size of its bond-buying program.
However, the truth is, they’ve been working in various ways to artificially suppress long-term rates almost nonstop since 2008. Then, when COVID-19 hit last year, they announced open-ended, unlimited quantitative easing.
That, combined with all the genuine economic pessimism at the start of the pandemic, pushed long-term rates below 1%, where they remained for the rest of 2020. Then came the new year, and rates started rising again. They haven’t fallen back below 1% since January 5th, and they hit a high of 1.74% on March 19th. They’ve leveled off a bit since then despite all the recent strong economic data that should logically be fueling more investor confidence.
The bottom line for investors who are retired, or nearing retirement, is that investing for income remains a viable way to achieve the retirement you’ve always envisioned. In order to get it right, you might have asked yourself “Should Investing for Income Be Part of My Retirement Plan?” You need to make sure you’re working with a Retirement Income Specialist who is knowledgeable about the best ways to actively manage your portfolio of individual, income-generating investments. By doing so, it can help better protect your retirement savings from economic uncertainties and market risk.
By the way, many people mistakenly believe that because they’ve made the switch to investing for income, that they can no longer participate in the stock market. Well, that’s not the case. For those who are able to take on some level of stock market risk, there are income-generating investments in the stock market that could make sense.
Originally published by The Retirement Income Store, 5/27/21
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