Burst of the Bond Bubble?

By Erin Klingbeil,

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Over the last thirty years, interest rates have steadily fallen, pumping up bond returns. Now that rates have hit rock bottom, many investors may find themselves in the middle of an imminent storm - the burst of the bond bubble. The potential for higher interest rates and inflation are brewing; thus, if we experience rising rates, bond prices have to fall. What does this mean for those who are invested with typical asset allocations prescribed for retirement?

Mainstream investment advice says that those who are retiring need to dial down their equity exposure and concentrate a larger percentage of their portfolio to "safer" or "more conservative" investments - bonds and cash. Many people believe that bonds add safety to a portfolio; however, the primary function of bonds in a retirement portfolio is to produce income.

In a standard retirement portfolio, you'll likely have 60% bonds, 30% stocks, and 10% cash (or something pretty close). Cash is seen as a buffer in a portfolio because of its relative safety, and the stock component is needed for portfolio growth. Bonds generate fixed income; however, it's rarely enough to fully support the investor.

What happens, then, is portfolio managers end up having to sell assets to produce more income. This is perfectly acceptable, except when it happens at a loss. Selling assets at a loss can create a serious problem known as reverse compounding . Reverse compounding can damage a portfolio to the point of no return, and unfortunately, it's only a matter of time before the retiree runs out of money .

So, if interest rates begin to rise and bond prices start dropping, what does that mean for the retired investor with his portfolio in 60% bonds? If you're holding bonds to maturity, it might not matter to you. But for the majority of investors, it means bond funds become a whole lot less attractive all of a sudden. These funds hold a "basket" of bonds with varied maturity dates, so the portfolio can take a beating as interest rates rise.

Start selling these at a loss because you need more income, and well, it's obvious why this way of investing in retirement is severely flawed. Lower bond prices will make life hard on anyone who has to pay for retirement.

The number one job of a retirement portfolio is to produce the cash flow necessary to fill the gap between your retirement expenses and any guaranteed sources of income that you may have (Social Security, pensions, etc...). Selling assets at a permanent loss and exposing yourself to the risks of reverse compounding is not acceptable. Take a good hard look at your portfolio and assess whether it's designed to meet your needs and address the challenges. If not, there is an answer ... you just have to be willing to make the changes necessary to position yourself for the best that your golden years have to offer.

The intent of this article is to help expand your financial education. Although the information included may be relevant to your particular situation, it is not meant to be personalized advice. When it comes to investing, insurance and financial planning, it is important to speak to a professional and get advice that is tailored to your unique, individual situation. All investments involve risk including possible loss of principal. Investment objectives, risks and other information are contained in the Snider Investment Method Owner's Manual; read and consider them carefully before investing. More information can be found on our website or by calling 1-888-6SNIDER. Past performance is not indicative of future results.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Personal Finance Retirement
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