I'm shocked to see how many average individual investors are still clinging to bonds. For many older investors, 50%-plus of their assets are in low-yielding US Treasuries (iShares Barclays 20+ Year Treasury Bond ETF: TLT). My jaw hit the floor when I heard this.
The common rationale goes something like this:
"Yes, government bonds provide very low yields but at least my capital is safe."
Unfortunately, nothing could be further from the truth and this way of thinking is going to lead to a retirement crisis. Let me explain:
1. Income is at risk: First of all, it is wrong to simply dismiss the impact low yields can have on an investor's portfolio and lifestyle. Today, if an investor wishes to live off coupons from 10-year US Treasuries, he'll need a $3-million-plus portfolio to generate about $50,000 in annual income. This is simply not realistic, considering the average portfolio size.
2. Capital is at risk: While 30-year Treasuries could rally to a sub-2% yield (perhaps when EU crisis 4.0 hits), the risk-return profile doesn't justify the opportunity. The 'rallying room' - that is the gap between current yields and the theoretical floor of 0% - is the smallest it has been over much of history. So to place so much faith in the continued flight to safety is to make an ill-balanced bet. The upside to yields is far greater than the downside.
True, investors holding US Treasuries to maturity will get their principal back. But you have to remember that when you're dealing with a super-low yield to maturity the real return is often negative to begin with. Buy-and-hold Treasury investors are facing major headwinds even if yields don't change.
But someday yields will normalize. That day may not happen in the next couple years, but it could. The markets are unpredictable. Did anyone five years ago forecast that US Treasury yields would be as low as they are today?
If yields continue to drop, Treasuries would rally, but I think investors should save the rate squeezing for the speculators. And that's okay. In fact, for the more sophisticated Seeking Alpha readers, this might be a viable trade. But it takes a lot of time, effort and intestinal fortitude to profit from the last 100 basis points of a 30-year bond bull market. So be warned.
However, for the average retiree looking to preserve their nest egg, it's time to dial down the exposure to US Treasuries. This doesn't necessarily mean reducing the allocation to 0%. But it is imperative that investors evaluate their vulnerability to a single market factor - interest rate risk - and diversify accordingly.
Disclaimer: This is not advice. While the author makes every effort to provide high quality information, the information is not guaranteed to be accurate and should not be relied on. Investing involves risk and you could lose all your money. Consult a professional advisor before making any investing decisions.