Analyzing Long Term Bonds In A Retirement Portfolio; 10-Year Treasurys Versus Dividend Stocks

Thursday, May 03, 2012 16:02
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Analyzing Long Term Bonds In A Retirement Portfolio; 10-Year Treasurys Versus Dividend Stocks

Tags: bonds | dividends | interest rates | retirement planning

Oh, how advisors and their clients long for the days when it was easy to earn 6% on a U.S. Treasury bond. The income alone was enough to see many people through their retirement years.

 
It used to be so simple for those approaching retirement:  Start trimming the portion of your retirement portfolio dedicated to equities and move into laddered, safe fixed-income.
 
Just 10 years ago you could get a 6% yield on a 10-year U.S. Treasury bond. Now you don’t even get 2%. With yields rising around the world on government debt, the risk/reward tradeoff for long-term fixed income is weighted way too heavily on the risk side these days.

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Much has been written on the debt problems of the U.S. federal government and how our public Debt/GDP ratio is now above 100%. More than a handful of analysts have predicted skyrocketing yields within the next few years as our debt moves ever higher. But these are arguments all subject to serious debate and it is very difficult to time when (or if) treasury rates will rise. However, what we can do is look at the risk/reward tradeoff objectively.
 
Let’s take a 10 year U.S. Treasury bond, which has a yield of 1.9% today, and see how the total return will fare in various scenarios.
 
Interest Rate
Movement (%)
One Year
Total Return
-3%
27.0%
-2%
18.6%
-1%
10.2%
0%
1.9%
1%
-6.6%
2%
-15.0%
3%
-23.4%
4%
-31.8%
5%
-40.2%
6%
-48.6%
 
If interest rates don’t budge over the next year, the total return on a 10 year treasury bond (before taxes) will be about 1.9%. If rates continue to fall, the return will of course be higher. But how far can interest really fall from here? If the 10 year treasury rate declines by 2%, we’re into negative yields for the 10 year, which has never happened. At that point investors would be paying the government to hold their money for them for 10 years.
 
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.
 
Treasury bonds used to mean safety. They used to mean a secure retirement for retirees. That has all changed. Not only is the interest rate risk greater than it used to be, but there is also what was unthinkable a decade ago: credit risk.
 
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.
 
So what can one do to get away from long-term fixed income and the risk that it entails? I 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 (JNJ), Procter & Gamble (PG), Wal-Mart (WMT), Coca-Cola (KO), Exxon (XOM), and Merck (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 3.5% 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
1.8%
19.5%
$119,530
Difference
2.4%
31.1%
$31,070
 
Dividend growth stocks can help a retirement plan immensely, especially versus low-yielding treasury bonds. I plugged in the 4.2% total return figure I found in our first example into our retirement planner in place of the ten treasury bonds that were in the portfolio before. I found that if a typical 55-year old couple with $400,000 in assets moves 50% of their funds from Treasurys to dividend payers that give them a 4.2% return, over ten years they will have increased the time that their funds last in retirement by over ten years. 
 
I have no doubt where my money would rather be right now. Even if an investor doesn’t want to hold any equities, I believe it is prudent to keep one’s money in short-term fixed income and wait until yields rise enough to make it worth the risk. 
 

 

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