Near-Zero Interest Rates Challenge Old Bond Portfolio Rules

With the Federal Reserve publicly committed to keeping short-term interest rates near zero until the end of 2014, investment advisers are scrambling to find sources of retirement income for older clients. In the process, some long-held views about the appropriate types of bonds in retirement portfolios are being challenged.

[See 10 Ways to Give Your Money a Makeover.]

"As those of us in the trenches craft portfolios for our clients who require income, many traditional asset allocation models no longer provide the stable income needed," says Lynn Ballou, whose Lafayette, Calif., firm advises clients in the Bay Area. The Fed's policy is understandable, she says, but "frustrating" for clients in and near retirement.

Ballou says her retirement portfolios were often based on individual bonds with a laddered mix of different maturities to generate stable streams of retirement income. Now, however, she has shifted more toward bond mutual funds because they offer more liquidity. Where appropriate for some clients, she adds, "we have changed our investment mix to include foreign and emerging-market fixed income and in some cases, added high-yield funds." On the equity side, yield is being emphasized by adding preferred and dividend-paying stocks.

"The first thing we talk with clients about is not how much risk they're willing to accept but how much risk they need [to accept] to reach their objectives," says Kevin Meehan of Summit Wealth Advisors in suburban Chicago. "We think in more instances that they're better off accepting a lower rate of return than taking on a higher rate of risk."

[See Do You Face 'Money Death' in Old Age?]

"We're not dramatically shifting because of the current interest-rate environment," he explains. Like many advisers, Meehan thinks the decline of interest rates during the past few years has provided bond investors with attractive capital gains. But with rates so low, he says, "bonds are more of a yield game at this juncture than about capital appreciation." And yields are so low that "yield-oriented investors are in a very perplexing situation."

"Most investors have spent virtually their entire investing lives in a period of falling yields and increasing bond values--bond heaven," says Marilyn Capelli Dimitroff, an adviser in Bloomfield Hills, Mich. "With rates near historic lows, the upside potential for returns in bonds is limited, and the downside risk, longer term, is large--the opposite of bond heaven."

Her clients' portfolios are generally composed of growth and stability portions, she says. The Fed's policy has "drastically reduced" income in clients' stability holdings. At the same time, the Fed's move has not altered clients' expectation for low volatility in fixed-income holdings. "As a result, we are more likely to increase allocations to equities than to chase yield [in fixed incomes] by extending maturities or compromising credit quality," she says.

[See Investors Scramble as Fed Extends Low-Rate Policy.]

Bill Driscoll provides insurance and financial investment services at his firm in Plymouth, Mass. He continues to believe that older clients should have a heavy weighting of fixed-income holdings. "The key is having one [bond portfolio] that won't be hurt when interest rates rise." While that's not expected soon, he thinks it's inevitable.

To reduce exposure to higher interest rates, Driscoll is emphasizing investments in floating-rate loan mutual funds that invest in short-term bank loans. They provide liquidity, diversity, and a short-term focus. Also, he notes, "they generally generate income every month" to clients. Payouts are either reinvested in the funds or swept into a client's money-market fund. Yields are running about 2 1/2 to 2 3/4 percent, Driscoll says. He also likes Treasury Inflation Protection Securities (TIPS), for their safety and as an inflation hedge.

[See Where to Invest in 2012.]

"It is a defensive" strategy, he acknowledges. "I don't think most people understand the nuances of different kinds of bond strategies," Driscoll concludes. "But they do understand the need to protect themselves from big losses. And they also recognize that they don't have very many ways to get a 2 1/2 percent return other than tying up their money for a long time."

Twitter: @PhilMoeller



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