Is It Time For Fixed Income In Retirement Accounts?

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 |  Includes: JNJ, KO, MRK, PG, WMT, XOM
by: Doug Carey

What a difference six weeks can make in our volatile markets today. The 10 Year Treasury was yielding 1.8% in late January. Today it stands at 2.35%. Is this the beginning of the long-awaited upward move in interest rates? With yields higher, is it time to move more money into fixed-income, especially longer-term fixed-income?

It is important to keep in mind that although yields are up by over 0.50% recently, there is a lot more room for rates to rise from here.

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The last time we saw a sustained increase in yields was in the late 90s. From 1998 through 2000 the ten year yield rose by over 2%. This was enough to knock nearly 15% off of the total return of a 10 Year Treasury bond. Let's look at just how the total return of a ten year bond would fare today under various interest rate movements:

Interest Rate
Movement (%)

One Year
Total Return

-3%

27.0%

-2%

18.6%

-1%

10.2%

0%

1.8%

1%

-6.6%

2%

-15.0%

3%

-23.4%

4%

-31.8%

5%

-40.2%

6%

-48.6%

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Looking at the scenarios when interest rates rise, we see how bad it can be. If the 10 year simply goes back to the levels that existed in the 2000, investors would see a -32% return on their investment. For a 30 year treasury bond, this scenario would produce about a -45% return.

I believe there is still way too much risk in longer-term fixed-income vs. the potential reward. The U.S. credit rating was notably downgraded by S&P last year for the first time in our country's history. It's obvious to most of us who follow the country's debt problems that the U.S. is no longer a AAA country. No country with $1.5 trillion deficits and Debt/GDP above 100% should be considered AAA; not even the U.S.

It also doesn't help matters that the Federal Reserve is now under pressure to raise short-term rates and at least stop buying longer-term treasury bonds. This pressure is due to the fact that consumer price inflation, especially in gas prices, is up substantially and the unemployment rate has fallen.

So what can one do to get away from long-term fixed income and the risk that it entails? I for one have been a big proponent of companies which have a reasonable dividend yield, low debt, make things we need, and have shown consistent dividend growth over time. Companies that fall into this category are Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG), Wal-Mart (NYSE:WMT), Coca-Cola (NYSE:KO), Exxon (NYSE:XOM), and Merck (NYSE:MRK).

Let's compare how a 10 year treasury bond might fare against a solid dividend payer like Johnson & Johnson over a 10 year time frame. Let's assume an investor buys $100,000 worth of a 10 year treasury bond and holds to maturity. Let's also assume he buys $100,000 worth of JNJ stock and the dividend growth over that time period is 5%, while the stock price doesn't move. Currently JNJ has a dividend yield of 3.4% and a 5 year dividend growth rate of 9.5%. I ran the scenario on JNJ in our publicly available calculator called Dividend Yield And Growth. This analysis assumes the investments are in a tax-deferred account.

Investment

Annualized
Return

Total
Return

Value of
Initial Investment

JNJ

4.2%

50.6%

$150,600

10 Year Treasury

2.4%

20.5%

$120,500

Difference

1.8%

30.1%

$31,070

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It is also interesting to look at how a typical couple approaching retirement might fare if all of their money is in treasury bonds earning 2.4%. Using our retirement planner I looked at a couple that is 55 years old, plans on retiring in ten years, has $500,000 in assets (all in tax-deferred IRAs), and will have $25,000 in social security payments per year. I also assumed 2.5% inflation and annual expenses in retirement of $50,000. The results I found are below:

Assets at Retirement (In Today's $)

$513,000

Age When Funds Run Out

82

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Running out of money at age 82 is not a pleasant scenario. This couple needs to do something different in order to make their funds last longer. What would happen if they moved half of their money to solid dividend payers like JNJ that could earn 4.2% per year?

Assets at Retirement (In Today's $)

$548,000

Age When Funds Run Out

86

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This couple is now in better shape, but certainly won't have a stress-free retirement. They would also need to either cut their expenses, retire later, or both in order to extend how long their funds will last.

Many investors will be tempted to plow back into longer-term bonds now that yields have risen. But this is likely just the beginning of a more sustained increase in interest rates. It's best to wait this one out, and in the meantime, find strong dividend paying stocks to provide solid dividend payments and income in retirement.

Disclosure: I am long JNJ, MRK, KO, XOM, PG, WMT.