Your Investments: Retirement investing: Look out, here comes the taper

Open up the business section or watch business TV and you are sure to find something about the Federal Reserve and “tapering.”

By AARON KATSMAN
The Federal Reserve building in Washington 390 (R) (photo credit: Jim Bourg / Reuters)
The Federal Reserve building in Washington 390 (R)
(photo credit: Jim Bourg / Reuters)
Open up the business section or watch business TV and you are sure to find something about the Federal Reserve and “tapering.” Everyone keeps talking about it, but what is it and how can you adjust your investment portfolio to prepare for it? Those focused on retirement investing should pay close attention because it will impact you the most.
Thomas Kenny of About.com explains: “Tapering is a term that exploded into the financial lexicon on May 22, when US Federal Reserve Chairman Ben Bernanke stated in testimony before Congress that that Fed may taper the bond-buying program known as quantitative easing (QE) in the coming months.”
In laymen’s terms, tapering is the slowing down – and eventual ending – of the massive Federal Reserve stimulus program that has been aimed at getting the US economy back on a solid growth track. The huge bond purchases of $85 billion a month have kept interest rates at historically low levels. The unintentional impact of this was that stock markets screamed higher as investors had nowhere else to generate any yield.
Retirees, who had grown comfortable watching the value of their US bond holdings rise on each monthly statement over the course of decades, suddenly reacted in horror as their June and July statements arrived in the mail, showing steep losses in almost all fixedincome classes. For retirees looking for fixed income, this is serious. What should they do? There are those that say to dump all bonds in your portfolio and move into dividend stocks. As I have written in this column many times, with dividend stocks you can achieve the 3 percent to 5% yield you need.
The problem is that for many retirees, the potential loss of principal that comes with stock investing is too much to handle.
Here are two sectors of the fixed-income market that investors may want to seek out in a rising rate environment: Individual bonds Investors holding bond funds may want to look at owning individual bonds instead. A mutual fund has no maturity or end date; it just keeps on going. In the case of a bond fund, the manager will continue to buy and sell bonds. The value of the fund is based on the value of its holdings, so if bond prices continue to drop, the value of the bond fund will drop as well. If we are at the beginning of a long cycle of increasing interest rates, bond funds have the potential to lose value for a long time.
By owning individual bonds, you know what you will get. If you buy a bond and hold it to maturity, you will get whatever yield you locked in at purchase and get your principal back at maturity. Though rates are still very low, they are moving up, so you can use a bond ladder to try and accomplish your goals.
What’s a bond ladder? Marc Prosser of Forbes explains: “You buy individual bonds with maturity dates that are spaced out over a number of years. When the bonds with the shortest maturities mature, you roll them over into the longest maturity you have chosen for your ladder. One of the purposes of a bond ladder is to protect you from rising interest rates. When interest rates go up, you are able to invest money at the higher rates as your short-term bonds mature, helping to offset the losses on your longer-term bonds.”
Global non-US dollar bonds
I know this is a continuing theme in my articles, but global bonds should have a respected position in most investment portfolios.
Believe it or not, investing in foreign bonds provides both value and stability. It’s all about the business cycle.
Alison Martier, senior portfolio manager of fixed income at AllianceBernstein, writes: “A US-only bond investor is affected by one business cycle, one yield curve and a single monetary policy. As long as rates were falling, that seemed like a good thing. Not so these days. Going global diversifies an investor’s interest-rate risk – and brings many other potential benefits. Although different countries‚ economic cycles, business cycles, monetary policies and yield curves may briefly align, over long periods they’ve not been highly correlated.”
While we may think foreign bonds are speculative and very volatile, surprisingly they are not. According to Douglas Peebles, chief investment officer and head of fixed income at AllianceBernstein: “In adverse bond markets, however, there has historically been a greater performance gap, with global bonds faring significantly better than US bonds. While US bonds declined 1.1% on average in down quarters, global bonds lost only 0.7%. That’s 62% of the downside of US bonds – a significant advantage.”
It is important to note that past performance is no indication of future results, and with all of these options there is the potential to lose money. It may pay to speak with a financial professional who has experience with these assets to see how they can be incorporated into your retirement portfolio.
The information contained in this article reflects the opinion of the author and not necessarily the opinion of Portfolio Resources Group, Inc. or its affiliates.
Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people with US investment accounts. He is the author of the book Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing.