Should I invest in fixed income for retirement?

Should I invest in fixed income for retirement?

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    For savers in their 50s and 60s, the question of where to invest your hard-earned pension savings becomes increasingly pertinent. One avenue for consideration is fixed-income investment. This involves purchasing debt securities, such as bonds or loans, in exchange for fixed, regular payments over a specified time.

    Fixed-income investing for retirement can be attractive to some as it offers a ‘flight to safety’ from the volatility of stock markets, as investors flock to perceived safer asset classes. As interest rates have increased in recent years, it also offers an attractive source of income.

    There has recently been a lot of interest and negative talk around fixed income as an asset class. In this article, we will touch on why that is, look at the importance of it as an asset class and help you determine whether they are the right fit for your retirement portfolio.

    Together, we will help you make informed decisions to shape your future, protect your family, and help you achieve financial freedom with our pension and retirement services. To learn more get in touch with us today.

    What is fixed income?

    Fixed income or bonds are debt investments issued by governments and corporations that raise capital. When an investor purchases a bond, they essentially lend money to a company or government, and in return, they pay a regular stream of income in the form of interest payments.

    At the maturity date, the bond is redeemed, and the principal and accrued interest are returned, assuming the issuer can do so.

    As you know both the price of a bond and the interest or coupon rate in advance, you can calculate the return from the outset. This is why they are referred to as ‘fixed income’.  

    For this reason, fixed-income investing is commonly known as ‘lower risk’ compared to equity investing. However, this depends on the bond issuer and the credit rating of the country/corporation.

    What types of fixed-income investments are there?

    There is a wide range of fixed-income investments, including:

    • Government bonds: For example, UK gilts or US treasury bills. UK gilts are considered relatively low-risk investments.
    • Corporate Bonds: Companies issue bonds to raise capital. These offer higher yields than government bonds but come with higher credit risk.
    • Local Authority Bonds (known internationally as Municipal Bonds): Issued by local US government authorities to finance public projects. We don’t reallt have an equivalent here in the UK.

    Fixed income securities can be investment grade or non-investment grade, the latter of which is often named as ‘high yield’ or ‘junk bonds’.

    The returns of high-yield fixed-income securities are generally higher than investment-grade debt. This is because the default risk of non-investment grade debt is much higher. As a result of this higher risk, fixed-income investors demand a higher return.

    Read our informative guide here to learn more about the stock market and bonds.

    Why fixed income investments performed so poorly in recent years

    Right up until the onset of COVID and even after it, central banks followed extremely loose monetary policy to stimulate economic activity, which was characterised by ultra-low interest rates and quantitative easing. This was because of benign inflation and low economic growth from the hangover of the 2008 banking crisis. 

    COVID hit and wrecked supply chains, causing a massive demand for certain goods and inflation to soar.

    Statista CPI index year on year from July 2013 to July 2023

    Once the “inflation is transitory” argument was proven wrong, and central banks realised it was much more stubborn than first thought, this led to regular and substantial interest rate hikes. 

    Fixed-income securities, particularly those with longer durations or long-term bonds’, can be very sensitive to changes in interest rates. Bonds move conversely to interest rates, a concept that can be confusing initially. When interest rates go up, the price of bonds goes down and vice versa. This is known as interest rate risk.

    You can see the impact of the dramatic rise in interest rates, which caused a decline (or rout) in bond markets. This is particularly noticeable with longer-term bonds, which are much more sensitive to interest rates.  You can see how longer-dated bonds lost almost 20% over the past few years which has led many fixed-income investors to question the preconceived notion of “stocks risky, bonds safe” and having a low correlation to one another. 

    How a rise in interest rates affect bond markets graph

    Advantages of fixed income investing

    If fixed-income investments have performed so poorly, this begs the question “Why should I invest in them?”. Here are a few reasons:

    Flight to Safety

    The first reason to still consider fixed-income investments in your portfolio is that they can offer defensive ballast to your portfolio when the proverbial hits the fan. Below is the performance of US stocks vs US Treasuries (government bonds) during some of the biggest stock market crashes of the past 50 years or so:

    performance of US stocks vs US Treasuries (government bonds) during some of the biggest stock market crashes of the past 50 years

    Here you can see that in some of the most significant drawdowns the stock market has ever seen, such as the banking crisis in 2008 when everybody thought the financial systems was going to implode, the US stock market fell over 50% from 2007-2008 and yet despite this, US treasury bonds were up 12% as investors sold risky assets and piled into fixed income as this was perceived to be a safe haven asset class.    

    It would be remiss of me not to highlight that this phenomenon has not played out during the past year or two when both stock and fixed-income investments sold off simultaneously. Partly because of a dramatic increase in interest rates globally to combat inflation, here in the UK, it went from 0.1% in 2020 to 5.25% as of November 2023.

    UK interest rates from 2020 to 2023

    If you remember the rule of thumb, ‘interest rates up, fixed income goes down’, this was never going to be conducive to fixed income investments, and we could see this with certain bond indexes down over 20%! Along with the war in Ukraine and equity valuations at high levels, this created a perfect storm for equity and fixed-income securities.

    Interest rates up, fixed income goes down graph

    Sequence of Return Risk

    I was once asked by a particularly aggressive investor at the point of retiring, “Why not just invest in equities?”. He said he was comfortable with the volatility of an all-equity portfolio, and over the long term, historically at least, equities have outperformed fixed income, so he would have more money. 

    Now this sounds all well and good in theory, but would you really be comfortable and act rationally if your drawdown pot of £300k was cut in half or more?

    The other issue with this strategy, however unlikely, is if we saw a Great Depression-type period such as 1928 to 1931. Looking at the data for US stocks (although I admit going back that far is a bit patchy), stocks were hammered. If you were also taking an income from your pension, this could affect the value of your whole retirement savings pot.

    This is known as the sequence of returns risk, the idea that the timing and order of investment returns matters.

    To put this into context, if the stock market crashed on the eve of your retirement just before you started to take an income from the funds, this would have a significant impact compared to someone still working and in accumulation, who could just wait until their funds recovered and actually buy investments at a relatviely cheaper price.

    Now turning to the performance of US treasuries over the same period, the returns on US treasuries were actually positive, so an allocation to fixed income would have really supported your retirement portfolio in this situation.

    US sequence of returns from 1929 to 1932

    Admittedly, a Great Depression-type event, in which there was no central bank and laissez-faire politics (a fancy term for no intervention), is in stark contrast to the world we live in today, in which central banks are much more interventionist. 

    A potential source of return

    As interest rates have risen, the fixed income yields are much more attractive than they were just a few years ago. The returns from fixed-income investments can now offer meaningful returns and provide a regular income and reliable income stream for investors.

    Working out the expected return on a bond or bond fund involves quite a complex calculation. However, a foolproof way of doing so is to calculate something called Yield to Maturity. This is the return you would get if you held the bond until maturity.

    Now don’t worry, you don’t have to get your calculator out. Most fixed-income funds, which most people invest in, calculate this for you.

    For example, I have taken the Yield to Maturity from the Global Aggregate Bond index, which tracks investment grade debt globally from 27 countries. The yield to maturity is approximately 4.40%, which is not bad at all. 

    How much should I allocate to fixed-income investments

    If you are considering an allocation to a fixed-income portfolio, you may be wondering what is the correct allocation to fixed income. This will depend on your risk tolerance, investment horizon and investment goals.

    What are the main risks of fixed-income investing?

    Although fixed income is perceived as a more stable income conservative, it has its own risks. Three of the main ones are:

    Interest rate risk – When interest rates rise, bond prices tend to decrease. This can be bad news for existing bond investors. However, this can make fixed-income securities more attractive for new investors as the yield tends to increase.

    Default Risk – This is the risk that the issuer, i.e. the company or country you lend money to, may not be able to meet its obligations and effectively not pay you back.

    Inflation risk – Inflation can be bad for fixed-income investors as it erodes the purchasing power of the coupon, which is the interest payment. Inflation will also reduce the principal. It is possible to mitigate this risk with inflation-linked bonds. However, the coupon or interest payments are usually lower.

    The value of investments and any income from them can fall and rise, and you may not get back the original amount invested. Past performance is not a reliable indicator of future performance and should not be relied upon.

    Looking to invest? Start with financial advice from Heritage

    At Heritage Financial Planning, we understand how complex retirement investment and planning can be. With over 30 years of experience, our team of seasoned financial advisers is dedicated to providing investment advice that aligns with your goals and risk tolerance.

    We guide you on whether fixed-income investing is the right path for you and help you optimise your retirement portfolio. By taking advantage of our expertise and understanding of market dynamics, you can make informed decisions that stand the test of time. Get in touch with us today.

    Conclusion

    In conclusion, investing in fixed income for retirement requires careful consideration of various factors. Fixed-income investments, such as bonds, offer a ‘flight to safety’ and can provide a stable income stream, particularly appealing to risk-averse investors.

    However, recent challenges, including the impact of rising interest rates, highlight the importance of understanding associated risks like interest rate sensitivity. Despite the poor recent performance, fixed-income investments still serve as a defensive ballast during market downturns, addressing the sequence of return risk.

    Ultimately, whether fixed income is suitable for your retirement portfolio depends on your risk tolerance, investment goals, and the evolving economic landscape. That’s why it’s essential to get the advice of a seasoned financial adviser like Heritage.

    Alex Norman-Jones​

    Alex Norman-Jones​

    I am one of the founders of Heritage and I am highly motivated to deliver bespoke financial planning solutions to my clients.

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