A Retirement Investing Strategy That Works

Steve McDonald By Steve McDonald
Bond Strategist, The Oxford Club

Bond Investing

If you’re over 45, you have one last window of opportunity to put together some kind of retirement. And if you plan on living above the poverty level in your “golden years,” it has to include more than just stocks.

Let me repeat that: You cannot own only stocks!

For the past 10 years, the stock market has returned nothing. And that zero return assumes you did everything correctly. Unfortunately, many have made the usual errors and are sitting on huge losses.

Over the last 30 years, investors were spoiled by the somewhat predictable returns they earned by doing nothing more than picking a well-diversified stock mutual fund. Over the long haul, 12% to 15% annually was very doable.

But that’s over! In fact, it hasn’t worked since 1999! And the market now feels completely unpredictable!

The seemingly random nature of the stock market has put an entire generation behind the retirement eight ball. Add up the cost of the errors most investors make, and you’re in a hole you may never escape.

In order to ensure that you come away with more than you started with, if the market offers a repeat act over the next few years, you must shift gears to a more predictable investment strategy. You must include the more predictable returns bonds offer.

Beating the Odds

The current default rate on corporate bonds, depending on the credit quality, is around 1% to 3%. That means they have a 97% to 99% success rate.

The long-term success rate of corporate bonds between 1925 and 2005 is about 94% to 99%. And yes, that includes high-yield bonds.

That sounds pretty predictable to me.

It’s not perfect, not a guarantee, but a whole lot better than what we’ve had to face for the past 10 years.

Even with a success ratio as high as 99%, there’ll be down periods and rough spots. Some will be rougher than others. But as you’ll see, the rough spots don’t really make any difference in your returns… If you deal with them properly.

Bonds Fluctuate, So What!

The biggest rough spot: All bonds fluctuate in market value.

You still earn the same coupon and current yield no matter what the market price is. But the market value of all bonds does jump up and down.

This market value fluctuation gives jittery investors another opportunity to sell at a loss. Because that’s what most investors do: They buy a stock or a bond, wait for its market value to drop, and then run like hell.

If that’s you, you’ll always lose money. It doesn’t matter what you invest in… You’ll lose. So, if that’s you, stop reading now and just take the tax loss.

Now, if you’re still with me, there is good news. Market fluctuation in bonds is not only expected, it’s predictable. It’s also a lot more manageable than fluctuations in the stock market. And, in bonds, you get paid no matter what the market value does.

You get paid your interest and – in 94% to 99% of cases – you get your principal back at maturity. If you bought the bond for less than $1,000, which is what I always try to do, you get the capital gains, too.

That’s predictability! Getting paid no matter what the market value does. That’s what you’re going to need to make it to retirement – a predictable return.

The Interest Rate Game of “Risk”

The chart below gives you a pretty good idea of how much Treasuries fluctuate in value when interest rates go up 1%, 2% and 3%. This chart is based on a 4%, 30-year Treasury. We’re currently at about a 3% 30-year, but this example will suffice.

1% 2% 3%
30 Year 84.55 72.32 62.58
10 Year 91.82 84.41 77.68
2 Year 98.05 96.15 94.29

A 30-year Treasury will drop from 100 ($1,000) to about 84.55 ($854.50) with a 1% increase in interest rates.

A two-year Treasury will only drop to about 98.05 with the same increase in rates. While this isn’t exact, it’s very close and very predictable.

Since we’re talking about corporate bonds – which, unlike Treasuries, aren’t guaranteed – we’ll see a greater drop in value. For a 1% increase in rates, we could expect to see a two-year maturity drop another 10%, or to about 88 to 90.

That’s a guesstimate, but who cares? We know there’s a huge probability that we’ll get our entire principal back plus interest at maturity. So, let the prices bounce around; it really doesn’t matter.

The fluctuations in all bonds are expected and the worse-case scenario is we wait it out to maturity. Then, we’ll get our principal back and collect our interest while we wait.

By the way, the reverse applies, too. As rates drop, the prices of bonds go up! In the past three years I’ve taken huge capital gains on bonds before maturity. But that’s for another article.

When rates move up, the best way to make money in corporate bonds is to do nothing… Just wait it out. Let the market jump around, let the Chicken Littles do their “sky is falling” routine. The best way to make money is to play the percentages and collect your interest.

Easier said than done!

Being able to see the end – or the maturity of a bond – gives most investors the confidence to sit tight and wait for their money.

But that’s “most investors,” not all!

Doing More Than MEAR-ly Surviving

Bonds allow you to know, before you invest one single dime, what will be your minimum expected annual return (MEAR). This alone can give you the psychological edge that’ll get you to – and through retirement – with enough money to do more than merely survive.

The MEAR has to be the focus of your bond strategy. If everything goes against you in the market, it’s the MEAR that you must zero in on. It’s like the light at the end of the tunnel.

Let’s use an example on how to calculate MEAR:

Bond X is rated B- and matures on 11/1/14. This is a very short maturity that keeps our interest rate fluctuation at a minimum. Let’s say, the coupon is 12%, but we can buy it for around 92.5 ($925 per bond) and it’ll pay us an annual expected return of about 17%.

That means you’ll receive six interest payments of $60 each, plus capital gains at maturity of $75 per bond (100 – 92.5). The holding period is around 33 months. Not including accrued interest, which is too involved to explain here, your return is:

6 x $60 + $75 / 33 months / $925 cost x 12 months = 17.1%

That’s 17.1% annually from a B- bond!

The real question is: Are you mature enough to wait and ignore the inevitable market fluctuations we’ll have between now and when this bond matures?

Predictability is really a test of your development as an investor. If you’ve reached the point where you can see two to three years down the road – and have finally realized that you can’t build a retirement on the occasional home run in the stock market – you can invest with a great deal of predictability with bonds.

Bonds are safer and more predictable than stocks. But you still have to use every tool at your disposal to reduce your risk as much as possible. So please, please don’t run out and buy Bond X… Not yet.

But that’s just an example. The basic rules of the road, – diversification, maturity, position sizing and a realistic level of risk tolerance – must be considered before you start building a bond portfolio.

There are alternatives to the joy ride and crashes of the stock market. And you’ll need to use all of them to navigate your way to a decent retirement.

Look for more predictability in your investments. For most of us we no longer have a choice.