Senior Market Comes Of Age

Bedrock Bonds Face New Threats

What does an inflationary environment mean for everyday retirement savers?

by John Ruth

Mr. Ruth is co-founder and CEO of Build Asset Management, an asset management firm specializing in strategies focused on fixed income and options.   

For the first time in more than a decade, we’re seeing signs of inflation in the U.S. Retailers, manufacturers, service providers, and consumers are all starting to notice it. According to one report, mentions of inflation on S&P 500 Q2 earnings calls have gone up 1,100 percent year-over-year. With the potential for a long stretch of inflation ahead, it may be time to sound the alarm for those wealth managers and retirement plan consultants who haven’t adequately addressed the conservative side of their retirement investors’ portfolios. This new circumstance is adding to the vulnerability of the American saver and it needs to be addressed.

In brief, we think that the fixed income portion of most 60/40 retirement accounts—the 40 percent bonds that’s normally matched by 60 percent stocks—is subject to new risks for retirees and soon-to-be retirees. Long considered the bedrock of conservative investments, bonds have entered dangerous territory, where low to zero interest rates combined with this new inflationary environment have put some bond issues into negative numbers. This could mean lost retirement income for American workers who have worked and saved all their lives in order to enjoy their golden years.

An Abysmal Agg

Let’s focus on the unfolding bond situation. In April 2021, the Bloomberg Barclays U.S. Aggregate Bond index, otherwise known as the Agg, showed an abysmal performance in the first quarter—a negative 3.4% return and the worst quarterly performance in 40 years. As of this writing, the Agg had rebounded into positive territory for the second quarter, but this is far from a stable moment for fixed income. Taking the Agg and inflation together, a normal bond with a less than 2 percent yield, minus a projected 5 percent inflation, gives a real yield of negative 3 percent. The price of those bond funds is also down year-to-date—so you’re getting negative price return and negative yield.

We think the prudent way to get yield at this time is to look at total return, as opposed to pure yield or income...

What should people be thinking about in terms of their fixed income holdings? So far, despite much higher levels of risk, nothing has changed in the way people are dealing with their portfolios—they’re just accepting it.

Urgent Call To Action

This is not a situation over which to be passive. Though it may be contrarian, we believe there are different creative ways to address the current fixed income crisis. Some fund managers have admitted that the low bond interest rate is tough to swallow and creates longevity risk for the client—they can outlive their money if they don’t get adequate return—and in response, they’ve replaced the old conservative side of the portfolio with more aggressive equities. Which is to say they’ve swapped out stocks for bonds. That introduces new risk—we’re trading one risk for another, perhaps an even bigger one.

In this scenario, loss of purchasing power and longevity risk is being reduced for higher degrees of equity exposure, market volatility and sequence of return risk.

There’s got to be a better way.

A Fresh Look At Total Return

It’s possible, for example, to invest in a way that addresses both the desire for protection and appropriate appreciation, longevity risk, and sequence of return risk. We think the prudent way to get yield at this time is to look at total return, as opposed to pure yield or income. To get a bit technical, in the current climate we can’t expect to produce fixed income yield, but we can reasonably offer total return on fixed income assets by capping them with equity options.

This equity option exposure allows the investor a one-directional opportunity to grow with a market that is being artificially supported in this turbulent pandemic environment. It’s possible, too, to deliver an experience consistent with the investor’s risk appetite and time horizon—for example, an investor in their 20s might go a little higher with the options and go out a little longer duration on the fixed income, than someone in their 50s.

Bonds are not a hedge against inflation—they are affected by it. But by getting to work finding new ways to protect the American worker’s hard-earned savings during these times, we in the industry can prove our own value while contributing to the greater good.