Jason and Emilia talk about bonds and risk in a rising interest rate environment.


Below is the full transcript:


Announcer: Welcome back America to sound retirement radio where we bring you content, ideas and strategies designed to help you achieve clarity, confidence and freedom as you prepare for and transition through retirement. And now, here is your host Jason Parker.

Jason: America welcome back to another round of sound retirement radio. So glad to have you tuning in in this morning. It’s my good fortune to have Emilia Bernal in the studio with me this morning. Emilia welcome back.

Emilia: Thank you. Good morning.

Jason: Good morning. So Emilia, the episode title this morning is number 157, seatbelts and Duration Risk. What in the world. But before we get started with the show let’s renew our mind. We do this with a Bible verse. This one comes to us from Galatians 6:2, and the verse reads: “Carry each other’s burdens, and in this way you will fulfill the law of Christ.” I love that, strikes a chord with me this morning. And then, we also like to put a smile on everybody’s face. You know, when my kids were little, I used to wake them up and go in singing, “You are my sunshine, my only.” Drives them nuts. But we are the sunshine in Seattle here, Emilia.

Emilia: We are.

Jason: And you’re bringing us the joke, so what do we got?

Emilia: Well here we go, so I’m going to go with a traditional knock knock joke today. So, knock knock.

Jason: Who’s there?

Emilia: Little old lady.

Jason: Little old lady who?

Emilia: Hey, I didn’t know you could yodel!

Jason: Yodel.

Emilia: Say it a little quicker.

Jason: Little old lady who?

Emilia: Little old lady who! That was my yodel.

Jason: That’s pretty good Emilia. Little old lady who. Okay, there you go Seattle, welcome, wake up, here we go, it’s another beautiful day. We’re alive, we’re on the right side of the grass.

Emilia: Yes.

Jason: So this episode is … Again the title is seatbelts and Duration Risk. But, I wanted to start out this morning asking you a couple of questions Emilia. The first one is, do you wear a seatbelt?

Emilia: I do yes.

Jason: Why?

Emilia: For safety, you know, you get in your car, you want to make sure if you’re in an accident that nothing, well not that nothing would happen, but you’re safer if there was an accident.

Jason: Yes. A friend of mine said when I asked him this question, he said, “You know I’ve heard that if you don’t wear your seatbelt the chances of you being thrown from the vehicle increases significantly, and so do, you know, some catastrophic impact results or possibly death.”, and so we found that it’s so important that people wear their seatbelt that it’s actually in the law now, right.

So the next question though, you wear your seatbelt mostly because of the accident factor, you know, that it takes a little bit of time, it’s a little bit of an inconvenience when you first get in your car but you decide to put it on. Let me ask you this, if you were going to wear a seatbelt, is it better to put the seatbelt on right when you get in the car, to try to put the seatbelt on right before the accident happens, or to put the seatbelt on after the accident happens?

Emilia: Right when you get in the car.

Jason: It’s kind of a stupid question, right.

Emilia: Yeah.

Jason: Because look, if you’re trying to put your seatbelt on right when the accidents unfolding, that’s probably not going to work out very well, and to go put your seatbelt on after you’ve been in an accident, what in the world, that’s crazy. The question is, why in the world are we talking about seatbelts, especially a stupid question like should you put it on before the accident. The reason is really quite simple, we’re in a really unique economic environment right now, we’ve got people heading into retirement and we have some risks that people need to be thinking about. Some of those risks are more obvious and apparent than others, and that’s why we’re going to be talking about duration today. But, if we know that there’s a risk on the horizon, if we know that there’s a possibility that we could get into a car accident, we want to buckle up and be ready for that before it happens. We don’t want to try to be scrambling during the midst of a crisis and trying to make adjustments, and we don’t want to wait until after it’s all over and said and done, the market’s tanked, or interest rates have skyrocketed, and then people are trying to make an adjustment after the fact. That just doesn’t make a lot of sense either.

So, it’s just really making sure that we’re being proactive, that we’re taking the right steps to protect, at the time that we should, and now’s a good time to be thinking about risks. Because we’ve been in this really calm time period, in terms of market volatility goes.

Emilia: Exactly. So, why are we going to talk about duration risk specifically?

Jason: Specifically, duration has to do with bonds, and it has to do … the biggest concern that I have right now is bond mutual funds. The reason that we need to have this conversation, and this is going to put some people to sleep and sometimes I get too technical on these radio podcasts, but the reason for this is, the generic general advice has been as you retire, people think of wanting more safety in retirement. Because, now they’re going to have to start drawing on that portfolio, or in many cases they will. So, the traditional advice has always been, well if you want more safety, historically bonds have been safer than stocks and so you create this diversification, this asset allocation where you have more money in bonds and less money in stocks, at least that’s what we see with a lot of the people that consult with us. They come in with these bond heavy portfolios, and there’s a known risk there with bonds, and so that’s why we need to talk about duration, because that’s how you measure the risk in these bond mutual funds. You want to understand what the duration looks like.

Emilia: So for our local listeners, I want to let you know that Jason has a retirement course that will be held at the local college campus, but if you can’t make the local courses consider signing up for our retirement planning webinar, which is where you can learn more about that on soundretirementplanning.com. So  go to soundretirementplanning.com to sign up for those courses or if you have any questions just get in touch with us. So I’m going to take you back though Jason, to where we’re going with our analogies here. So what does this have to do with your seatbelt analogy? The duration risk and everything we’re discussing.

Jason: Yes, so a couple of things, a couple of sound bites from recent events that have taken place. Number one, you’ve got Bill Gross out there. Bill Gross is considered the bond king, amongst many people. For many years managed the PIMCO Total Return Bond Fund, and now he’s with Janus, oversees a lot of money. He recently said that we are now in a bear market for bonds, that means that’s bad news, right. That we had been in a bull market for 30 years because interest rates have been declining, and probably just kind of a little bit of a primer here for people that don’t really understand bonds and interest rate risk, and why Bill Gross would say something like this. Essentially what happens with a bond, is if you buy a bond today and interest rates go down, then it makes that bond you hold worth more. The opposite is also true. If interest rates go up, the bond that you hold becomes worth less if you have to sell it before maturity. So Bill Gross’s point in all this, is that bonds interest rates have been declining for the most part for the past 30 years, and now we’re in a different environment where the Federal Reserve last year increased interest rates three times, and the statement that they made in December, was that the plan was to continue to increase interest rates three more times in 2018.

So, you’ve got these bonds experts, like Bill Gross who come along and say, hey, the bull market for bonds is over, we’ve entered into bear market territory because interest rates have gone up, you’ve got the Federal Reserve who says we’re going to be increasing interest rates, and you’ve got retirees who are trying to make this transition into retirement, they want more safety, and so they’re putting more money into bonds, which could be even riskier than they imagined. Because they’re making decisions based on what’s happened in the past, they’re not thinking about what has happened in the future.

So, getting back to the seatbelt analogy, you want to put your seatbelt on before the accident happens. You don’t want to be scrambling to try to make adjustments in the middle of a bad situation, and you certainly don’t want to wait until the dust has settled and then try to put your seatbelt on, that’s just not very smart. And so, you’ve got all these people heading into retirement, they’re all getting this advice that you need more bonds in your portfolio for more safety, and they’re not really thinking long-term about, or I guess short-term, they’re not thinking short-term about the impact and the results, of this new economic environment that we find ourselves in today.

Emilia: That’s great, that’s really helpful. So what can investors do to better understand their specific duration risks?

Jason: And again, my biggest concern here is with people that own bond mutual funds. If people own individual bonds, they have the ability to hold those bonds until maturity. So they can navigate, they can manage that risk a little bit better, they don’t have to sell. But, in a bond mutual fund, which is what I find most people have, they don’t necessarily have a maturity date. They don’t have an instrument that they can hold until maturity, and that’s where this duration risk really comes into play.

A great resource for our investors is to go to morningstar.com and put in the ticker symbol of the mutual fund that you own. Now, if you don’t know this language, you don’t know what a ticker symbol is, and you don’t know how to navigate through Morningstar, of course we could help people understand this if they need our assistance. But you want to … and some people don’t even know that they own bonds, because they’ll own a fund that, maybe it’s called an income fund, and many times those funds are very heavily weighted in bonds, they don’t even know what they own, they’ve just been told by their stock broker that they should have 60% in bonds and 40% in stocks. Many times they don’t even know that much. So,  I think that’s one of the scary things about all of this, is people don’t really know what’s going on inside these different investments that they hold.

So you go to morningstar.com, you put in the ticker symbol. And I did this, just out of curiosity, I went and I researched the top three bond mutual funds, and people can do the same Google search I did, say hey you know, what are the largest bond mutual funds by assets under management. And then I went into Morningstar and I looked at each one of these funds and it was interesting to me, and on average most of the funds were paying somewhere around two and a half percent, was the 30-day SEC yield, according to Morningstar. And people need to do their own research on their own funds, but this is what Morningstar had said about these three funds that I looked at. What was interesting though, is they said that the duration of those of those three funds, in each case I believe that the duration was six for each of those three different funds, or six or higher.

And so, why that’s important to people, is if interest rates go up 1%, there’s a direct correlation between duration risk and interest rate sensitivity. So if you own a bond mutual fund today, and you have a duration of six, and interest rates go up 1%, then the expectation is that that bond and mutual fund would drop, would fall by 6%. Do you see that correlation? If you have a duration of six, and interest rates go up 1%, then you would expect the bond mutual fund to drop in value by 6%.

So a very logical question to ask is, if you’re getting compensated two and a half percent in terms of the yield that you’re earning, and the Federal Reserve has come out and said that they’re going to be raising interest rates three times in the next year, and somebody like Bill Gross, who some people call the Bond King, says that we’ve entered a bear market for bonds, is that a known risk that people should be thinking about strategically as they’re getting ready to make this transition into retirement? And I think it is. I think it’s a very important thing that people need to be thinking about.

Now on this show, we’re not we’re not making any investment recommendations, we’re not telling people to sell mutual funds, we’re not telling them to buy mutual funds, but we just want to help them understand some of the complexities that people just generally don’t think about, because they don’t spend all of their time … most people don’t enjoy personal finance.

Emilia: So why do you think people end up in a bond-heavy portfolio when these risks are so obvious?

Jason: Well again, it just gets back to … you know, I heard somebody once say, “You wouldn’t drive your car by only looking in the rear-view mirror.” That’s not a very smart way to plan on moving forward, is to only look in your rear view mirror. That’s why every prospectus you get on a mutual fund says past performance may not indicate future results, right? Everybody’s warning you, just because this has happened in the past, doesn’t mean that this is what’s going to happen in the future. But, as portfolio construction goes, a lot of the advice that people are getting is based on, if this is how these asset classes have performed in the past, then we’re hoping they’re going to perform a similar way going forward. And if we’re looking at bonds that have a 30-year track record in an interest rate environment that’s been falling, and we expect bonds to perform the same way during that period of time as a rising interest rate environment, it’s setting people up potentially for results that they weren’t planning on.

And so, it’s just getting people to think a little bit about these. I mean I wrote about this in my book, Sound Retirement Planning, and that was published three years ago, so this is while we’re in this environment, that I warned people would be coming, we’re on the cusp right now of this accident getting ready to unfold, and people still haven’t taken steps to really understand what that means.

Emilia: Okay. So should people worry about risk, or is risk just noise?

Jason: I want to answer that question, but back to your last question. There’s one other thing I wanted to say there. One of the reasons people have these bond-heavy portfolio’s, is because they don’t really understand what the purpose of their money is, right. They go in and they answer these risk tolerance questionnaires, which doesn’t mean a lot to most people, they don’t really understand. Other than, most people understand, hey if I have a million dollars today, I don’t want to lose $300,000 in the next six months. I mean that becomes very real to them, all of a sudden they understand that risk.

But when you go through this exercise, and you’re using that past performance of these asset classes as your gauge for how your money should be allocated, then what you end up with is a portfolio that’s heavy in bonds, especially for retirees. The other thing is, a lot of retirees are looking for income. They want cash flow from their portfolio. And it used to be, there was a time when people could retire Emilia, and they would just go out and buy a municipal bond funds or paying 4% or 5% tax free, never touch the principal, and they could have a pretty good life. But in an interest rate environment, where 10-year treasuries are paying two and a half percent and some of these bond mutual funds have a yield of two and a half percent, that’s going to be hard for most retirees to live on that interest income alone, and so many retirees are looking for safety and they’re looking for income, and that’s how these bond-heavy portfolios happened.

But, I’m sorry about that, I just wanted to make sure we got that point across.  I think your next question was-

Emilia: Yes, so why should people worry about risk or is risk just noise?

Jason: This is a really great question, and risk is noise, as long as your time horizon is long enough. Risk becomes real, when all of a sudden, you have to start dipping into the portfolio. And so, when you get this advice from people like Jack Bogle who says, you know when the market is getting wonky or getting … you know, there’s a lot of volatility, just stop opening your statements. Well, that’s really great advice, especially for the young people that have a long time horizon before they need their money.

The concern that I have though, is that retirees, they’re not adding to those portfolios anymore. What they have is what they have. Risk is noise until you need to start accessing the portfolio, and then risk becomes very real. Because, if you’re pulling money out of an account that’s falling in value, you’re not adding any more money to that account, you’ve got a bad situation that’s going to get worse, as a result of what we call reverse dollar cost averaging. Maybe a more powerful visual for people is you will hear me oftentimes say, if you’re taking money out of an account that’s falling in value, it’s like being stabbed and going to donate blood at the same time. You’ve got a bad situation and you’re making it worse.

So again, it just gets back to what the purpose of the money is. Why do you have it in the first place, what are you trying to accomplish with it. Once you understand that … and that all comes from having a good plan, not just from having a diversification asset allocation strategy.

Emilia: So, I want to reminder out listeners about our upcoming retirement planning webinar. Jason will help you walk through a planning process and strategy, to help you have more confidence as you prepare to retire. The webinar will not be recorded, and is only a live event. It will be held on Monday, January 22nd at 5:30 p.m. Pacific Standard Time, and 8:30 p.m. eastern time. So if you have any questions or want to learn more about Jason’s discussing today, and more, please sign up for our webinar.

Jason: The key to all of this, and the reason we’re doing the webinar, is because we want people have a good plan. All of these other decisions about how your money should be invested, they’re a secondary component to the plan first, and most people don’t even know what a good plan should look like, because most people don’t have one. So, if we can walk them through our process Emilia, show them in the webinar exactly the type of work that we do for people, then at least they’ll have a baseline to work from. If they’re going to create their own plan or if they’re going to hire somebody to help them, they’ll know what a good plan should look like, and then they can start making some of these decisions about asset allocation and how much do you have in stocks and bonds, and how are you going to generate the cash flow that you need from these assets, so you can have the lifestyle that you want in retirement.

Emilia: Yeah, absolutely. So do we have time for a couple more questions?

Jason: Yeah.

Emilia: Okay great, so Jason just to go back, if bonds may not have the same benefits as in years past, should people heading into retirement still own them?

Jason: Yeah, so we just spent the last 20 minutes beating up on bonds, right. And now, I’m going to say people, there is still a place for bonds. And here’s the hard part with this, is you have to understand time is the cure to the volatility of the stock market. So, when you’re creating a broadly diversifies portfolio across asset classes and sectors, bonds historically have had a cushioning effect when the stock market gets really wobbly. We tend to see a lot of money flow into bonds, especially institutionally, treasuries have been the safe haven, that’s where money would typically flow if people are trying to run from risk. And so, even though you’re not getting a whole lot of interest today, and even though there’s this duration risk, bonds still have this cushion, at least they have historically has this cushioning effect when stocks get really wobbly. So, can it make sense to have bonds in a portfolio? Sure it can, as long as the time horizon before you need those funds is long enough.

So, for people that have a 10-year time horizon … you know one of the strategies we like to talk a lot about, is diversifying across time. So  you have your short-term, your moderate-term, your long-term money. Long-term money is 10+ years. If you have a 10+ year time horizon, well yeah, it can make a lot of sense to have some bonds in that portfolio to  help diversify, create a cushion on the downside to help reduce the volatility, instead of just having an all-stock based portfolio. It’s just making sure that you’re holding those bonds within the correct position, based on when you need the money. The other piece is, getting back to people that own individual bonds. I’m not as concerned there, because again, they have more control over this duration risk, than people that own the bond mutual funds, or the bond ETFs, or some of  these other structures.

Emilia: All right. So my last question for you today is, how will the tax cuts impact the economy and investing?

Jason: You know, this is pretty exciting actually. Warren Buffett recently was quoted as saying that he would not have necessarily proposed this bill before Congress, he wasn’t a big fan of that legislation. But, then he talked about being a shareholder for one of the railroad companies that he’s heavily invested in. He said you know as a shareholder for the railroad company, I would have had to have voted yes for this, because it basically means that our company’s going to have 20% more money to work with.

So, one of the things that could happen going forward … because you know we’re in this, again this unique economic environment where bonds have been artificially impressed because the federal … depressed, because of the federal government doing this quantitative ease in. They’ve been buying bonds and increasing their balance sheet, and they’ve been slashing interest rates, so that makes a weird environment for bonds. But then you have stocks that are some of the highest prices we’ve ever seen historically, based on things like the CAPE ratio, cyclically-adjusted price-to-earnings. And so, I think it’s good that when you’re doing retirement planning, you should go into this cautious.

But, but there are some things happening in the economy right now that are positive. One is, you just put … I mean for a lot of these corporations, 20% back into their coffers. That means a couple things could happen. Number one, historically what a lot of companies have done, is  they’ve used money to buy back their own shares, so we could continue to see share buybacks, which could cause stock prices to continue to go up. Oftentimes, companies will pay down long-term expensive debt, so we could see some bonds that they hold being paid off. You could see increased dividends or dividend growth, for people that own dividend-paying stocks. You could see more investment in new ideas and technology, which could mean more jobs, it could mean better pay for people.

So, there’s a lot of things happening in the economy right now that say, hey this economic environment we’re in from a stock standpoint, really could continue to ratchet forward, because of these stock cuts, and this is some of the biggest tax reform we’ve seen … I mean not stock cuts but tax cuts, some of the biggest tax reform we’ve seen in 30 years, there’s definitely going to be a significant impact, we don’t really know how that’s going to play out. But, we are going to be doing an event in February to talk about tax planning for retirees.

I want to get back to the basics though, because we developed some software recently called the retirementbudgetcalculator.com. All this stuff can seem overwhelming to people. If people want to have a greater sense of confidence as they head into retirement, if they can just dial in their spending, understand how much they really spend, life is going to be so much better, and so that’s why I developed that software, the retirement budget calculator, because that’s the piece that people have the most influence over. it’s probably the most important number in their entire financial life, and most people really don’t understand how much money they spend.

So before we worry about asset allocation, diversification, stocks versus bonds, versus income, should you have an annuity in your portfolio, I mean before any of that stuff, let’s just get the basics right and get that budget dialed in.

Emilia, with that, we’re just about out of time. You’ve been listening to episode 157 Seattle, You Are My Sunshine-

Emilia: My only sunshine. I should take up yodeling.

Jason: Until next week, this is Jason and-

Emilia: Emilia.

Jason: We’re signing out. Remember, you can sign up for these events at soundretirementplanning.com.

I want to thank you so much for listening, for subscribing on iTunes, being a podcast listener, and for the reviews, we appreciate those as well. That helps other iTune listeners find us. Until next week, this is Jason signing out.

Announcer: Information and opinions expressed here are believed to be accurate and complete, for general information only, and should not be construed as specific tax, legal or financial advice for an individual, and does not constitute a solicitation for any securities or insurance products. Please consult with your financial professional before taking action on anything discussed in this program. Parker Financial, it’s representatives or its affiliates have no liability for investment decisions or other actions taken or made by you, based on the information provided in this program. All insurance-related discussions are subject to the claims-paying ability of the company. Investing involves risk. Jason Parker is the President of Parker Financial, and independent fee-based wealth management firm located at 9057 Washington Avenue, Northwest, Silverdale, Washington. For additional information call 1-800-514-5046, or visit us online at soundretirementplanning.com.