Retirement Watch: Revisit Bond Strategy

OCEAN CITY – Though the bear market in stocks has gotten most of the attention, the financial crisis wreaked havoc on bond investments as well. Treasury securities, whose backing by the U.S. government makes them a reliable choice for mitigating portfolio risk during volatile times, did very well in 2008, but virtually every other kind of bond suffered losses, with the lowest-quality bonds generally faring worst.

Now that it appears that the biggest risks for the economy may have passed, we recommend that retirement-focused investors — especially ones whose retirement plans have a bit of time to recover and who are willing to assume more risk — consider moving down a bit in quality in order to potentially obtain more competitive yields than those available from Treasury securities, says Martin Mauro, Merrill Lynch’s Fixed Income Strategist.

A full-fledged economic recovery may still be some time off, but when it comes, it could affect bond investments in several ways. When business and consumer activity picks up, inflation often rises, and that could lead the Federal Reserve to increase the interest-rate targets it controls. Higher inflation also reduces the value of interest income from bonds, and when newly issued bonds offer higher yields, existing bonds become less popular, depressing their prices. Also, as appears to be happening already, some investors may also have more of an appetite for risk in an improving economy. That can benefit lower-rated bonds at the expense of high-quality investments.

These shifts, as they develop, could affect your choices for a fixed income portfolio. Cautious investors may continue to prefer Treasuries, but, Mauro notes, there appear to be good opportunities among higher-quality investment-grade bonds. And municipal bonds, another fixed income option, may also deliver higher after-tax yields than comparable Treasuries provide.

Approach municipal bonds with a degree of caution. The state and local governments that issue these securities are under severe pressure in this recession, and if the economy worsens, default rates could rise, warns Mauro. To offset the risk inherent in these bonds, it’s important to seek out higher-quality munis that may have more secure revenue streams. Mauro advises focusing on general obligation bonds, which are backed by the full taxing power of municipalities, and essential-service revenue bonds, which support such vital systems as water, sewer and power operations. Rather than allow such bonds to default, governments will typically raise taxes or take other steps to cover interest payments. Mauro also believes that it’s important to hold a varied basket of munis for diversification.

In addition, Mauro notes that Build America Bonds, a product of this year’s federal stimulus package, are attracting a lot of attention. These bonds are obligations of the municipalities that issue them and aren’t guaranteed by the federal government. The interest they pay is fully taxable at the federal level. If you’re considering Build America Bonds, Mauro suggests, evaluate how they stack up against other bond choices.

Many high-quality investment-grade corporate bonds with intermediate-term maturities now yield more than 5%. That could be attractive as long as the issuer is a solid company and the bonds carry a strong investment-grade rating. Mauro cautions against a high allocation to corporate bonds that are rated below investment grade. If the economy remains in recession, shakier bonds could suffer from rising default rates.

An improving economy, however, with rising inflation and interest rates, could hurt the value of all kinds of fixed income investments. Bond laddering can provide needed flexibility. To build a bond ladder, your financial advisor can help you invest in Treasuries, municipals, corporate bonds or CDs with staggered maturities of, say, one, three and five years. Then, when one bond matures, you can use the proceeds to buy another at the long end of the maturity spectrum. “With a laddering strategy, your portfolio can be more diversified and you may have the opportunity to reinvest at higher rates if yields rise,” explains Mauro.

There is no guarantee that inflation will rise soon, and some experts disagree about the outlook. But by holding a diversified fixed income portfolio that includes TIPS and other higher-quality bonds, your retirement plan could be prepared for whatever challenges — and opportunities — tomorrow’s markets present.

(A Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-8520.)