Bond Investing in a Low-Interest Environment

This week, Gail discusses bond-investing strategy -- an important issue for retirees and others in search of investment income in today's low-interest environment.


Hello Gail;

I love reading your retirement articles even though I retired a couple years ago. I learn all I can from those type of articles. Since retiring, I have all our IRA money in a return bond fund and it has done well.

The trouble is, the price per share is at a high because interest rates have dropped so much. I know the relationship with bonds and interest rates and I know once the economy begins to move again the Federal Reserve will have to raise rates and the bonds will drop in value. I want to preserve the capital. Is there any good way to do that other than invest it in the market again?


Dear John -

While 40-year lows on interest rates have been a boon for people who borrow money-- home buyers and corporations, for instance -- they are not helpful for people such as yourself who count on the interest payments from their bonds to provide income. In some cases, retirees have seen their incomes drop significantly.

You are correct that the price of an existing bond moves in the opposite direction as interest rates. As a result, although bond investors have experienced a drop in income over the past two years, some have also enjoyed a tremendous increase in the value of the bonds they own -- either individually or through a mutual fund.

For instance, last year more than 50% of the total return an investor received on a 10-year Treasury bond came not from interest payments, but from price appreciation, which was a direct result of continued reductions in interest rates. At some point, that appreciation is going to evaporate.

Although it probably won't happen right away, eventually we will see interest rates increase. That's because it is the main tool the Federal Reserve has to "cool off" the rising prices that typically accompany a growing economy.

In an expanding economy, where consumers and corporations are optimistic about the future, spending tends to increase. Because of strong demand, the sellers of goods and services can raise their prices. That's when the central bank steps in and starts raising interest rates. Higher interest rates make both consumers and corporations think twice about making additional purchases. This reduces "demand" and makes sellers less likely to raise their prices further, thus keeping inflation in check. 

The dilemma people such as yourself face right now is, how do I preserve the gains I've seen in my bonds thanks to the decline in interest rates and ensure that I don't give it all back when rates start to go up again? And how do I do so in a way which also provides me with the income I need?

It isn't easy. But the key is to do what seems like the most difficult thing: cash in some of those profits and re-invest the money elsewhere. Even as a retiree you need to own stocks (yes, I know what the stock market has done in the past three years!). Your biggest risk is not losing principal, it's losing purchasing power. By that I mean your dollar doesn't buy as much as it used to.

The only way to overcome this is to increase the number of dollars you have. That's what people mean by "growth" in capital. Sure, it's great that your CD will still be worth $10,000 when you cash it in 5 years from now. But if that $10,000 only buys the equivalent of what $8,400 buys today (assuming the things you spend your money on are going up at an average annual rate of 3%), then your lifestyle will decline.

Historically, the investment that has consistently enabled your money to grow over time at a rate that exceeds inflation is stocks. So consider re-deploying some of your bond profits in a well-managed, diversified portfolio of equities. Mutual funds are an efficient way to do this.

There is a very broad selection of funds available and each carries certain types of risks -- be sure you review a fund's prospectus thoroughly before investing.

As a retiree, you probably also want to look at dividend-paying stocks. Even if President Bush's proposal to eliminate the tax on corporate dividends is not enacted, companies that pay dividends could see their stock prices appreciate. That's because in the wake of Enron, WorldCom, Tyco, etc, wary investors are looking for tangible evidence that a company is not playing accounting games. One way to demonstrate this is to pay a dividend.

By the way, I wouldn't restrict myself to U.S. stocks. Consider investing some of your money in an international mutual fund that invests in large, dividend-paying foreign companies. Or consider a "global" stock fund. This kind of mutual fund invests both in US and foreign companies. (You need to consider that international investing involves certain risks, such as currency fluctuations, economic instability and political developments.)

Alan Peters, a 36-year veteran of the financial planning industry, says you might also want to put some money in a mutual fund that invests in convertible preferred stocks. These pay higher dividends than common stock -- in the range of 6-7% currently. In Peters' view "you can enjoy the income and have the flexibility of the preferred converting into common stock if the market "takes off." In light of the tension in the Middle East, he would also invest some money in a natural resources fund.

Peters, who holds both the CLU (Chartered Life Underwriter) and the ChFC (Chartered Financial Consultant) designations, owns his own advisory firm in Wilmington, Del. He says in terms of bonds, "high-yield is the sweet spot right now." Bonds that are rated triple-B (the highest quality "junk" bond) have a current yield of around 6.5%. Bonds with lower ratings are yielding in excess of 11%. If the bond fund you own isn't allowed to invest in high yield or junk bonds, then he recommends investing some of your proceeds in a pure high yield mutual fund.

However, those high yields should send up a red flag. There's a reason these bonds are paying so much and it has everything to do with risk. As with any mutual fund, you should read a high-yield bond fund's prospectus carefully to make sure you understand the additional risks these bonds carry. Don't invest too much in this sector but do take advantage of the diversification a mutual fund can give you. If one or two out of a hundred bonds goes bad that has a much smaller impact than if one or two out of five individual bonds you hold does!

Finally, if your existing bond fund gives its managers the flexibility to move into different areas of the bond market (high yield, for instance) and adjust the "duration" -- a measure of interest rate sensitivity -- of its holdings, don't give up on it entirely. This is one of the advantages a mutual fund offers over individual bonds: the managers of the fund can adjust the portfolio in order to react to changes in the financial environment much quicker and at a much lower cost than you could in your own account. You should know that individual bonds have guarantees if held to maturity, while the value of mutual funds will fluctuate with market conditions and there is always the possibility that you could have a loss rather than a gain when you sell your shares.

And don't forget cash. At a time like this it can be smart to keep some money liquid so you can take advantage of unexpected opportunities. Your goal should be a balanced portfolio, diversified among different asset classes so that you can weather whatever the financial markets deliver in the years ahead.

Diversify, be patient, don't get greedy.

Best wishes,



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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.