The equity (stock) market has done very well so far this year, and I hope it continues, but it is volatile and there is a real danger of the market making another significant correction. If you’re younger, in your 40s or early 50s, that isn’t necessarily be an issue, but if you are retired and living off of your investments, even a moderate decrease in your portfolio can have a significant impact over the long term.
For example, let’s say your portfolio is worth $100,000. If there is a 20% correction in the market, you would lose $20,000 and the value of your portfolio will drop to $80,000. You might think that a subsequent market return of 20% would get you back to $100,000, but you would actually need a market return of 25% to get you back to where you started (1.25 X $80,000 = $100,000). If the market lost 50%, you would need a 100% return to get back to where you were. This can take years when you are retired and are no longer contributing to your retirement accounts.
The safest way to mitigate the volatility in the stock market is to invest a portion of your investment portfolio in investment grade bonds, notes, CDs, and other fixed income tools that are available.
But if you’ve been following the financial markets lately, you know that fixed income investments are paying very little interest right now. You can see this just by looking at the interest rate of your savings and money market accounts.
There are several ways you can increase your interest rate “yield” on fixed income investments. One way would be to purchase lower quality “high-yield” bonds. But high yield bonds are subject to default risk and not as safe as investment grade bonds.
Another way to increase yield would be to purchase longer term bonds. Longer term bonds pay more because they are more sensitive to interest rates. But with interest rates already low, it doesn’t make sense to invest in long-term bonds by themselves and assume the added price risk (as interest rates go up, prices of the bonds go down).
There are a couple of strategies you can use to increase your bond returns without adding risk. The first is by using bond ladders. In a bond ladder we purchase investment grade bonds of varying maturities so that a certain amount of them mature each year and we can use the funds as they mature to purchase higher yielding bonds (assuming interest rates are going up). As I mentioned above, the longer maturities will pay more than the shorter maturities. But the interest rate risk is removed because you are holding the bond to maturity and you will always get the face value of the bond back at maturity.
The second method we use is “hedging”. You can purchase longer-term bonds that pay higher interest, and still avoid some of the interest rate risk by also purchasing investments that pay off when interest rates rise. These can be inflation protected securities like TIPs or Ibonds, or you can purchase securities that “short” treasury bonds (these increase in value as treasury bonds decrease in value). The timing, type, and amount to invest in a hedging strategy should be left to professionals, but it is another way to lower your risk while still getting a reasonable fixed income return.