Q: We have three Registered Retirement Income Funds (RRIFs). One RRIF from which I plan to draw on next year is a self-administered plan. In preparation for the withdrawals and ensuring adequate cash, so principal is not used as long as possible, we only have three very long term bonds (10.25%, 10% and 7.30%). First call in 2039 for two and the other expiring in 2029. Of course, we paid a premium for these bonds but the “yield” averaging 7% seems “reasonable” and would provide adequate cash for at least 7 to 8 years or more before the capital would need to be touched. Looking at various write-ups on the subject of retirement, it sometimes bothers us as maybe it was not a good idea to place all the funds in this RRIF (about $111,000) in long-term bonds.—AJ
A: Bonds are such a tricky asset class. I think a skilled investment adviser can provide more value helping manage fixed income these days than stocks, but few advisers are well versed in bonds. Stocks are where the money is, but perhaps now more than ever, bonds are getting the attention they so richly deserve.
According to a 2011 publication by McKinsey & Co., global stock markets totaled about $54 trillion at that time. Bond markets tallied nearly three times as much—$157 trillion. Despite the importance and size of bond markets, you don’t hear much about bonds on the 6 o’clock news. Stocks have more sizzle and the financial industry makes better profits trading stocks than buying and holding bonds.
If you’re looking for yield in bonds, longer term bonds tend to have higher yields. Short-term bond rates are similar to GIC and mortgage rates these days, unless they’re more speculative bonds.
Bonds actually play a big part in GIC and mortgages rates. The 5-year fixed mortgage rate tends to track the 5-year government of Canada bond rate, albeit a bit higher. And GICs are how the banks borrow money from you to lend to other people (or back to you) as a mortgage, with a profit built into the spread, of course.
Bonds have actually been a great place to invest over the past 30 years—especially long-term bonds. If you bought a 30-year bond in the early 80s and held it to maturity, you probably earned a double-digit annual return that may have exceeded your stock returns. Rates dipped a lot during the 80s before continuing a slow downtrend to where they stand currently.
When you hear tales of caution about bond markets these days, the risk doesn’t lie so much in buying a bond and holding it to maturity. Other things being equal, if you buy a 20-year bond yielding 4% and hold it to maturity, you’ll earn 4% annually until then as long as the issuer is there to pay back your principal. The potential losses are based on the capital value between now and then and what happens when interest rates rise, especially if you need to sell before maturity.
Other things being equal, a 20-year bond could fall as much as 20% if interest rates rise by 1% (if you’re in a zero coupon bond). If your 20-year bond is paying a 6% coupon or interest payment, that same 1% rate increase would cause an immediate 11% price drop. The reason bonds fall when rates rise is because newly issue bonds become immediately more valuable and existing bond prices need to fall to the point where their yields to maturity are similar to new bond rates for the same maturity.
Bonds have been bid up in price and therefore their rates have been bid down so much that it’s hard to argue that rates aren’t artificially low currently.
To be earning a 7% yield on your bonds, you’re definitely not invested in government bonds, AJ, but more speculative bonds. Long-term Government of Canada bonds maturing in 10-30 years have yields ranging from 1.5% to 2.1% currently.
I’d suggest that you need to evaluate whether a 7% yield to maturity is worth the potential, albeit interim capital losses you will experience when rates rise. In particular if you end up needing more than the minimum withdrawal on your RRIF to fund your retirement, including in the event of an emergency situation, you’re that much more likely to dip into capital and be forced to sell these bonds at potential losses. You have acknowledged yourself that you think you might need to sell in the next 7-8 years, long before they mature.
If you’re going to take stock-like risks to earn 7% returns, I might be more inclined to consider stocks, or some stocks, as an alternative.
If bonds make sense for this RRIF, to be invested in just three bonds is not a well-diversified portfolio, especially these more speculative bonds. You might be better served to consider selling in favour of a bond fund (mutual fund or ETF). The fees might be worth the diversification, but with $111,000 to invest, you could consider being in a few more individual bond positions instead of just these three. I’d have a bias towards shorter term bonds regardless, especially as a DIY investor.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.