How to Avoid a Dangerous Overreaction to Low Bond Yields
Inflation adjusted returns are roughly zero, but bonds remain essential
Playing it safe once again carries a high price.
Federal policy and investor sentiment amid the coronavirus crisis have caused the yield on cash savings and bonds to plummet. The best online high-yield bank savings accounts are struggling to pay 1%. The core bond fund you’re likely relying on in your 401(k) or IRA is paying a barely-there 1.25% recently.
And there’s growing chatter that there are better options that earn a higher yield. Dividend stocks. Preferred stocks. Junk bonds. Even more drastic is talk by some that it no longer makes sense to own bonds given they aren’t earning much of anything.
As frustrating as rock bottom yields are, abandoning cash and high quality bonds requires you accept boatloads more risk. A three-step guide to avoiding an overreaction:
Step 1: Get a grip on the big picture.
Today’s epically low rates mark a return of the war on savers. During the financial crisis, rates were close to zero on bank savings deposits and short-term bonds. What hurt savers was seen (by policymakers) as a necessary enticement to get people to borrow and invest. As the economy came back, rates slowly rose: one-year Treasury bill to more than 2.6% in late 2019.
The ability to earn an interest rate above the rate of inflation was short lived. The one-year T-bill recently had a yield below 0.15%.
The low yields don’t take inflation — the annual pace at which the cost of stuff rises — into account. A positive “real” yield means you’re earning more than the inflation rate. A negative real yield means every dollar you save or invest isn’t earning enough to keep pace with inflation, eroding your future standard of living: https://www.rate.com/research/news/low-inflation-decimate-retirement
Step 2: Understand the risk of higher yielding alternatives.
Dividend paying stocks are S.T.O.C.K.S. An index of stocks with a long history of raising their dividends currently has a yield of 3%. That’s compelling. But recall that in the furious sell-off earlier this year, the price of the SPDR S&P Dividend Index ETF fell more than 37% in barely more than a month. (At the same time, your core bond fund lost less than 2%. A portfolio of intermediate term Treasury bonds — the best stock hedge — rose 4%.)
Preferred stock. This is a special class of stock that a company issues that pays a fixed interest rate. Typically, the rate is a lot better than the dividend the same company might pay on its common shares. The largest exchange-traded fund (ETF) that tracks an index of preferred securities currently yields more than 5%. But during the bear market earlier this year, the price of the portfolio lost 31%.
Junk bonds. Think of junk bonds as lending to a company with a low FICO score. That relatively higher risk compared to bonds issued by more solid companies means junk bonds tend to perform more like a stock when things get rocky. An ETF of junk bonds that was yielding around 5.5% before the recent bear market saw its price drop more than 23% during the worst of the sell-off.
Step 3: Use a strategy of short term (safety first) and longer term (beat inflation).
Cash is still the smart choice for emergency savings. This isn’t about what you earn. It’s about what you can tap at a moment’s notice. The nominal value of a bank savings account won’t fall. Knowing the $10,000 at the bank will always be there is a whole lot smarter than putting it in a dividend paying ETF and, just when you need cash, it's down to $6,500.
Don’t pile more into cash. The standard advice is at least three months of living costs set aside. Six months is better, given the volatile nature of our economy. If one year’s savings helps you sleep better, go for it. For retirees, a popular strategy is to keep a bucket of cash equal to at least two years of living expenses. But beyond that, low yields will penalize you.
For long term investments, bonds will always make sense as a diversifier. When the world goes crazy, high quality bonds stand their ground. If you are younger than 45-50 and know you absolutely won’t panic during a bear market for stocks, there is an argument for not owning bonds. But that’s a huge commitment. To move everything to stocks and then bail out of stress when stocks are falling will likely do irreparable damage to your savings.
Once you’re within 15 or so years of retirement, owning bonds is a diversification imperative. How much depends on your personal situation. But let’s say at 50 you would have 40% of your portfolio in bonds. That’s still a sound approach. If you really are itching to earn more, maybe downsize bonds to 35%. That gives you 5% more in stocks, which over the long term have the best track record of inflation-beating gains.
If you’re retired and want more income, get it from your stock portfolio. Moving a big chunk of your portfolio-calming bond allocation into stocks is a big risk. Instead, think about repositioning stocks you own. Shifting more of your stock allocation into funds or ETFs that focus on dividend payers or preferreds can increase your income payouts, but without changing the overall risk level of your investment strategy.
Stop thinking like your parents and grandparents. Living off of income is over. Yes, earlier generations were able to “clip coupons.” That’s not our reality. The war on savers has only illuminated a trend that was in place long before the Great Recession: In a low-rate world there is no safe way to live off income. Own cash for emergencies, bonds for diversification, and invest in stocks for a shot at inflation-beating growth.