I hate to be the bearer of bad news, but baby boomers, you’re about to have a hell of a time getting paid.
So are the rest of us, but you’ve got it far worse right now.
Right as you are transitioning into income-generating investments at the fastest rate, you’re being set up for some steep losses, years of pitiful yields, or both.
Yes, the Fed is finally going to do something about near-zero interest rates, but it won’t do us any favors.
Either through target date funds, managed 401(k)s, or other retirement accounts, we’re all being herded into the same investments, and there are already signs that the traditional income generator — bonds — have no capacity to absorb more investors.
In fact, the bond market has a slew of problems already, well before the peak of the generational transition to “safer” investments.
First, let’s look at two possibilities for what will happen to bonds in the next several years, then let’s check out two solid options we have to avoid this pitfall.
Outflows and Losses
We all know the Fed is going to start increasing interest rates, creating quite a problem for existing bond holders.
The price paid to buy bonds has been sky-high for quite some time. As new bonds with higher yields are issued, the value of existing bonds will drop.
This, in turn, will drop the value of retirement savings placed into bonds.
Even worse, this will create an incentive to pull money out of bond funds. This has the potential to hit retirees pretty hard.
Let’s say you have a portion of your 401(k) or retirement funds invested in a bond fund. The market is then hit with an interest rate hike, making the current value of your investment in the bond fund fall due to the inverse relationship between bond prices and bond yields.
Investors aren’t happy with this, and they worry about further rate hikes driving down the value of their investment even more, so they start selling their positions and looking for greener pastures.
To deal with this outflow of money, the bond fund will have to sell bonds and realize a loss on behalf of fund participants to cash these investors out.
Now there is less money invested, and anyone remaining in the bond fund will ultimately see a smaller total return on their investment.
This cycle can self-reinforce, as we saw with the PIMCO Total Return Fund back in late 2013, making a bond fund’s performance as subject to the whims of investors as those of central bankers.
Drying Up
The next potential problem has to do with what exactly these funds invest in.
A very bizarre thing occurred recently, where bond prices went negative. Yes, we should all laugh at someone paying someone else to borrow their money.
However, a lot of the buyers didn’t have much of a choice.
Virtually all bond funds have some limit to the creditworthiness of the bonds they purchase. Some only invest in the best sovereign bonds. Others in high quality corporate bonds.
As you can undoubtedly imagine, a whole bunch of previously pristine credit ratings were lost during the Great Recession, and a vast majority of those have not recovered.
For many bond funds, this means that there is a far smaller amount of total debt that they are allowed to purchase, and they have to bid up their competitors.
This is exactly why some bonds saw negative interest rates. There simply wasn’t enough debt to fulfill the mandates of institutional bond buyers, and they had to pay such a premium that the return went negative due to the inverse nature of bond prices and yields.
To put it simply, the bonds that funds are allowed to buy are becoming scarce due to demand.
It is quite possible that this continues unabated even as changes that normally would increase bond yields — such as the fed increasing interest rates — go into effect.
This would keep high quality debt prohibitively expensive and push anyone seeking income from yields into riskier and riskier junk bonds.
These bonds are issued by companies with worse credit ratings, either because of business problems, already large debt, or both.
In other words, the very debtors that will do the worst in a rising interest rate environment. Worsening credit ratings and rising defaults are all but inevitable.
Two Ways to Avoid These Scenarios
Now, to the good part — how to insulate yourself from these two possibilities.
Both immediately dodge the first scenario of plunging values of bond prices because they generate income in a different way.
First up are what many call “baby bonds” or preferred shares. Here is why the nickname is fitting.
Preferred shares are a form of debt. However, they are traded in the exact same way that shares are traded — through public exchanges and with much smaller face values, often as low as $25 instead of the standard $1,000 for bonds.
These shares are designed to pay dividends, and they often pay higher yields than comparable debt issued into the bond market.
While preferred shares do tend to drop in value as interest rates rise, the drop is normally significantly smaller.
Bonds, preferred shares, it is all debt. Choosing higher yields with smaller potential drops is an obvious choice.
The Outsider Club‘s Jim Collins is an expert on these investments, and will be bringing you more world-class analysis of these “baby bonds” in the very near future, so stay tuned.
The other option you have is to go for the best income paying stocks in the market.
There is a select group of companies that has done something pretty amazing. Over the last 25 years, they have increased their dividend payments every single year.
They did it through three recessions: the 1990 to 1991 debt and oil shock, the dot com bubble aftermath, and the Great Recession.
Constantly increasing dividends for shareholders every year has become a given, and they’re going to continue doing it to keep their investors happy for many years to come.
Though there is a risk of share prices dropping with the market, investors will continue to see their dividend payments go up.
Plus, there is the added bonus of long-term appreciation. Unlike debt, which simply exists, these companies are consistently growing and increasing their value as well as that of their shares.
Boomers that are retiring soon can count on the steadily increasing income, while choosing when to cash out of positions over a much longer timeframe than bonds.
Jimmy Mengel is our resident expert on these companies, and has compiled a wealth of information on them.
