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The COVID-19 pandemic has caused financial chaos. Many eyes are focused on the stock market, massive government spending programs, and oil prices. Are we underestimating the fundamental change that will have the biggest long term financial impact for retirees?

falling interest rates

As of May 8th, 2020, the interest rate on 10 year treasuries is .63%. The 20 year treasury rate this same date is a paltry 1.05%. Your reward for tying up your money for 30 years? 1.31%. 

These rates are all time lows. If the economy needs further stimulus, Americans could soon see interest rates on treasuries go negative for the first time ever. Other major economies in Europe and Asia are already there.

This is a fundamental shift. Do bonds make any sense in this environment for a retiree who needs income? If not, what are your alternatives?

Traditional Roles of Bonds

There are three “truths” about bonds that make them staples in most investment portfolios. Let’s review them before we go any further.

“Truth” 1: Bonds Provide Income

Most retirees and institutional investors use bond interest as a relatively safe and reliable way of creating passive income. This is a simple concept that almost everyone understands. 

You loan your money to a government or corporation. A bond is a promissory note to pay back your principal plus a defined premium for the use of your capital.

“Truth” 2: Bond Values Increase When Stock Values Decrease

Interest rates are often lowered to stimulate economic activity in times of financial crisis. When interest rates drop, existing bonds with higher rates become more valuable. The longer the bond duration and the larger the interest rate drop, the more valuable existing bonds become.

Having an asset not closely correlated to stocks, even if it is highly volatile like a long term bond, can decrease overall portfolio volatility. Selling appreciated bonds creates another way to produce income when stock prices are down. It also allows you to buy more stocks at depressed prices when rebalancing your portfolio. Thus bonds provide diversification to stocks.

“Truth” 3: Short and Intermediate Bonds Provide Stability

High quality short and intermediate term bonds are far less volatile than stocks. They can prevent catastrophic drawdowns during major stock market crashes. They are also not as vulnerable to interest rate increases as are bonds which have longer durations. 

The shorter the duration and higher the quality of your bonds, the more stable they are. This is another diversification benefit that bonds provide.

Reexamining Bonds In An Extreme Low Interest Rate Environment

When you understand these principles, it’s clear why bonds have been a cornerstone to a diversified investment portfolio. These “truths” have held well over the past 40 years as interest rates have dropped in a mostly linear fashion from all time highs to all time lows. 

This is all many investors have ever known. With current interest rates near zero, it is worth stepping back to reexamine the role of bonds.

Bonds Income When Rates Are Extremely Low

The idea of lending your excess money and collecting interest is at least as old as biblical times. It was one of the earliest financial concepts I remember learning as a child, and one I’m currently teaching my seven year old to incentivize her to save.

Joe Weisenthal does a good job explaining that in current times there is more money than worthwhile places to deploy it. Cash needs to be stored. 

You could store money in your home where it is at risk of fire, theft, etc. Or just like a classic car, fine art work, or gold coins that provide no financial value until you transact them, you can pay to store your money.

If rates go negative, a bond adds an expense you have to support in retirement. Buying negative yielding bonds is the equivalent of renting a storage unit for your cash.

With low rates the past decade, most bond investors have already accepted that their bond interest won’t meet their spending needs. Even a conservative withdrawal rate of 3% won’t be met by bonds yielding 1-2% without selling off principal. And that ignores the effects of inflation that make those interest payments less valuable over time.

Ben Carlson recently pointed out how absurdly low the income currently produced by bonds is compared to historical standards. If rates go negative in the US as in other industrialized nations, it will completely disprove our first “truth” about bonds.

Volatility and Speculation When Rates Are Extremely Low

As I’ve been pondering the second “truth” about bonds, several people pointed me to an article from the website Portfolio Charts. It argues for the Benefits of Bond Convexity

The article demonstrates two key mathematical points about bonds when interest rates are low. First, long bonds become more sensitive to small rate decreases. Second, risks and benefits of a change in interest rates are asymmetric. A drop in interest rates increases a bond’s value more than an equivalent increase in rates hurts it.

The article was enlightening. But it is all based on one assumption by the author. He writes:

“If I had a nickel for every time I heard someone say they think bonds are poor investments because ‘rates have nowhere to go but up’, I’d be able to buy an island! But the simple fact is that they can always go lower, and because of convexity they really don’t have to move very far at all to turn a major profit.”

This argument has worked and will continue to work… until it doesn’t. Interest rates will likely reach a floor and stall or go back up. Morningstar’s John Rekenthaler provides a different opinion, writing Long Bonds Are for Fools

Long bonds are purely speculative investments in this environment. Admittedly, I’ve been wrong speculating how low the floor for interest rates could go since I got serious about investing. In early 2013, interest rates were at (then) all time lows of about 2% for 10 year, 2.7% for 20 year, and 3% for 30 year treasuries.

Rates could continue to fall even lower than current all time lows. If they do, the second truth will hold. When we eventually reach a floor where they don’t, long bonds will get crushed.

Stability When Rates Are Low

The good news is the third truth holds well. Short-term U.S. treasuries continue to be a safe place, insulated from the wild gyrations of the stock market and largely immune to interest rate risk. So why not just shift all your bond holdings to short term treasuries?

The cost of devoting a large portion of your portfolio to these risk free assets is giving up income as well as potential for price appreciation. A retiree’s spending would come almost entirely from depleting principle.

Inflation will likely diminish the spending power of your money. This strategy guarantees you’ll eventually run out of money unless you have enough that you’ll run out of life first.

Going to short-term treasuries only for the short term introduces different challenges of trying to time interest rate changes. This is at least as hard as trying to time the stock market. 

If the 30 year yield drops another percent, would you then accept that maybe “rates can always go lower”? That would mean getting back into long bonds after they’ve gotten even riskier and you’ve missed tremendous gains. 

What if long bond rates go up by 1% per year over the next two years. That would put the 30 year yield at 3.3% which is still more than 1.5% below long-term averages. Rates would be trending upward. Would you feel good buying long bonds then? 

There are no easy answers.

What Are the Alternatives?

Low interest rate environments create a challenge for people looking to retire. This is not new. Todd Tresidder wrote about the Great Bond Bubble in March of 2013. 

I’ve shared my portfolio which is light on bonds and written about strategies external to a traditional investment portfolio to address low interest rates and high stock valuations. 

Few people predicted that we’d go from an already historically low interest rate environment in the early 2010s to a more extreme low interest rate environment in the early 2020s. 

There is no single magic bullet for dealing with current extreme low interest rates. Having been dealing with already low rates over the past decade, we have to continue with more of the strategies we’ve already been considering.

More Risk In Your Portfolio

Respected experts may bristle when they see adding risk as the first strategy. The reality is, there’s no alternative. 

I’ve already focused on the increased inflation risk and interest rate risk as well as most people guaranteeing they won’t meet spending needs when choosing U.S. government treasuries with extremely low yields. 

High quality corporate and municipal bonds offer more yield. Junk bonds offer even higher yields. 

That’s because they come with higher default risks in addition to the risks of securities. These  risks are more apparent now given the economic uncertainty created by the pandemic.

Another strategy to create more income is investing in real estate investment trusts (REITs) for their higher yields. However, REITs are typically highly leveraged, so they are more volatile than bonds in normal times. 

These are far from normal times. Regional mall REITs were down over 60% and lodging/resorts were down over 50% in the most recent quarter according to the website Nariet.

Gold has been proposed to be a better diversifier to stocks than bonds in this extremely low interest rate environment. Still, gold is highly volatile and creates no income.

Cryptocurrencies have the same issues as gold with volatility and producing no income. They also lack gold’s history of increasing in value when panic reigns.

Giving stocks a higher allocation of the portfolio is another option. This provides a reasonable hypothesis for why stocks have fared reasonably well so far this year. 

Investors may be chasing dividend yields and potential for price appreciation, both of which are greater than yields and upside potential of bonds. However, this is likely making already volatile stocks even riskier than usual.

Whether we want to take on more risk or not, we have no choice. All asset classes are more risky with rates at extreme lows. We simply have to pick our poison.

More Emphasis On Social Security

We can look external to our traditional portfolios to offset some of the risk. One big lever that traditional retirees can pull is optimizing their social security claiming strategy.

It may seem intuitive to claim Social Security sooner if your portfolio is currently down, giving your investments time to recover. Mike Piper and Christine Benz each have recently written compelling arguments for why that is likely a bad idea.

Tools that may be useful in helping make the best decision considering your specific circumstances are Piper’s Open Social Security calculator to maximize your benefit and our affiliated Pralana Gold retirement calculator to see how this decision impacts your overall financial situation.

More Work

Early retirees or younger traditional retirees may not have the option or desire to claim social security. But we have a major advantage that many traditional retirees don’t have: the ability to earn more money.

There are people who still push back against the idea of working in retirement. Extreme low interest rates may make people rethink that position.

In a post on choosing your safe withdrawal rate, Darrow highlighted the impact of earning $1-2K/month from a hobby business or part-time work in retirement. Compare the effort it would take to earn that much income versus the amount of capital you would need to accumulate to create that income from bonds in the current low interest rate environment.

The current yield on a ten year treasury is .63%. It would take about $1.9 Million to create $1K/month and $3.8 Million to produce $2K/month at that rate of return.

Another option that could create more income is investing in real estate. This would require more work and has different risks than traditional stock and bond investments. In this interest rate environment, the risk and effort may be worth your time.

More Focus on Spending

Optimizing social security and working more focus on the income side of the retirement equation. Retirees also can decrease the amount of money they spend from their portfolio.

The same principles that enable you to lower your spending on the way to financial independence apply in retirement. If you want to reduce your expenses, it is best to address your largest areas of spending that deliver the greatest benefits.

Housing and Transportation

For most people that means looking at housing. Carrying a mortgage may seem like an intuitive decision with mortgage rates being very low. A quick search of current mortgage rates shows that a 30 year mortgage is about 3.5% and a 15 year mortgage is about 3.0%. 

Long-term investors should be able to get returns greater than this over thirty years. But what about over the next 10-15 years, when retirees need income and face sequence of returns risk?

It’s highly unlikely you’ll obtain a 3% return from bond investments in the next decade. More stocks mean more volatility and greater sequence of return risk with no guarantee of returns. Paying off your mortgage to eliminate this expense may make sense.

Downsizing your house can also offer considerable savings. You can decrease two major expenses simultaneously if you also move to a location that allows you to eliminate a vehicle or otherwise decrease transportation expenses.

Taxes and Healthcare

Taxes and healthcare costs are large expenses that can be reduced with good planning. For early retirees planning to buy insurance through the ACA, this planning overlaps. 

ACA premium tax credits drastically impact what you pay for insurance. The subsidies are based on your Modified Adjusted Gross Income, giving more incentive to decrease your income needs.

Roth IRA conversions are another consideration that can decrease your overall tax burden, particularly if you convert when stocks are down and tax rates are low. It is also worth considering the impact of drawing from Roth, tax-deferred and taxable investments in different amounts and sequences.

All these decisions are complex and could impact one another. Having a tool like the Pralana Gold Retirement Calculator or working with an expert on tax planning can help you piece together this complex puzzle to optimize your personal situation.

More Money to Retire

These solutions may not be attractive to you. Few people want the stress of taking on more investment risk in retirement. 

Doing some work in retirement can have benefits that extend beyond the financial gains. Work can provide purpose and meaning that many people struggle with in retirement. Still, it is different choosing to do work you want versus having to hustle to make ends meet.

Trying to squeeze more dollars out of government programs or cutting spending on things you find important in order to save money in retirement is not appealing to many people.

The other option is to simply save more. Conventional wisdom has been that a 4% withdrawal rate is safe for a 30 year retirement, a bit less for early retirees

I despise doom and gloom scenarios.The research the 4% rule is based on encompasses extreme conditions that include the Great Depression, world wars, periods of high inflation, and massive societal and technological changes. 

One thing we’ve never seen are interest rates this low. There is no precedence. Retirement researcher Wade Pfau sees “3% being a lot more realistic than 4% as a sustainable strategy in a low interest-rate environment” for a 30 year retirement timeframe. That number may be even lower for early retirees.

Deciding whether you have enough money to retire securely means embarking on an experiment with a sample size of one. Failure is not an option.

If you are unwilling or unable to be flexible and creative with spending and earning in retirement, the alternative in these challenging times is to work longer and save more to create the secure retirement you desire.

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at chris@caniretireyet.com.]

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