In response to my article last week here at LearnBonds, a retired reader asked me about the risk similarity between high-yield bond ETFs and equities, since they both bounce around in price. I told the reader that while there is certainly risk to investing in both types of assets, the risk is difficult to equate. Bond risk is relative to the credit of the underlying issuer and, on an interim basis, to the duration of the bond. Bond ETFs are generally priced efficiently relative to the pooled pricing of the underlying holdings, but in a rising rate environment, capital could be at permanent risk. Equity risk typically emanates from the quality of a company’s earnings and the general supply/demand for ownership of the stock. Stock pricing on a near-term basis can be highly irrational. Capital put to work in stocks is always at permanent risk, with no contractual guarantee of principal.
The fact that we cannot clearly delineate the level of comparative risk that is being taken from asset to asset is one of the challenges of allocating monies in financial markets. Further, with rates at historic lows, bond investors continue to need to up credit and/or duration risk to attain yields/returns that were accessible by much less riskier methods in prior years.
Though bond bears continue to accentuate the potential risks of owning fixed income in a rising rate environment, few seem to point to a secular low-rate scenario. If rates were to continue to remain low for the foreseeable future, bonds would not seem to be the “dangerous” asset they are sometimes portrayed to be. On a similar level note, stocks have been portrayed as a dangerous asset to own today since markets are trading near record highs and valuations are “above average.” Of course, we could remain “above average” for longer than one might anticipate or expect.
Thus, the loud, echoing hollers of risk in today’s markets makes asset allocation decisions more difficult than any other time in recent memory. While the safest place to be when risk abounds is in cash, unless you possess executive or movie star wealth, the returns from 1-2% CDs and “premium” 1% money markets today won’t pay the bills.
While each retired investor’s assets, goals, and risk tolerance will vary, a sound investment course of action to follow is that of diversification. Owning different asset types at different parts of the corporate capital structure enables investors to spread the risks that each investment entails. Though some investors may be predisposed to owning only stocks or only bonds, in reality a mix of both assets is probably the safest course of action.
Stocks, particularly dividend growth stocks, while exposing retirees to capital fluctuation, offer a rising stream of income that fights inflation. Despite the inherent risk, dividend growth stocks also offer total return potential that bonds seemingly possess very little of today. And since many dividend growth stocks have solid business models that have survived many recessions, they may be perceived as possessing lower volatility than more aggressive stocks that don’t pay a dividend and/or erratic revenue and earnings streams.
And though the coupon from an individual bond in most cases will not grow until its time to maturity, it does offer peace of mind insofar as capital and interest payments are concerned. Bond funds, given their net asset pricing, up the capital risk ante, especially in a higher rate environment, but offer instant diversification which may be quite desirable for those looking at bonds with lower credit quality.
While it’s really impossible to provide an asset allocation percentage blueprint that would end up being appropriate for all retired investors, diversification would seem to mitigate at least some of the risk that is being forced on a portfolio due to low interest rates. Owning a varied assortment of income producing stocks including consumer-oriented blue chips, utilities, REITs, and limited partnerships alongside corporate, municipal, high-yield, and perhaps specialty fixed-income would seem to be an all-weather solution for the benign yield and stormy risk climate in which retirees currently live.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.