Feb 26, 2013
By Rick Law Elder Law Attorney and Senior Estate Planner In Chicago, IL
Investment number 2: Bonds and other fixed income debts.
One of our favorite legal clients, Fern, called in a panic one day and breathlessly cried, “I’ve been defrauded! I bought some high return bonds and this month’s statement shows that I’ve lost a lot of money!” As we spoke with Fern it became obvious that she didn’t understand what a bond is, nor how a bond’s principal value can fluctuate wildly.
In the investment world, a bond is a security that represents a contract between a borrower (corporation, governmental body, banking institution) and a lender—you. A bond is usually a fixed interest loan.
A bond loan arrangement uses terms that are unfamiliar to most. If you buy a bond, you are lending money to the borrower, who is the issuer of the bond. The bond loan terms detail what interest will be paid to the lender. The interest is called the coupon, and since the lender gets to hold the bond, they are called the holder.
The basic relationship between a borrower and lender is well known to all. What makes a publicly traded bond so different is that the basic fundamental principal value of the bond fluctuates.
Bond principal value fluctuations are caused by:
Fern had wanted a higher interest on her investment money than what she could receive from bank CD’s and money markets. She went to a broker and emphasized that she wanted more income.
He sold her some “junk bonds.”
It is important to understand that the term “junk bond” does not always mean that the bond is trash. Any high-yield bond that is not of a sufficient quality to be considered investment-grade is considered more risky and speculative. These bonds have a higher risk of the lender defaulting.
They pay a higher rate of interest, but they are not the best choice for protecting widows and orphans, and Fern was a widow. She wanted higher income, but she was very risk-averse.
When the value of her bond went down, she panicked and sold the bond at a loss—even though I had shown her that the actual income from the investment was still high, compared to the alternatives.
Today many baby boomers, seniors and elders have moved trillions of dollars out of the stock market and fled to bonds of all types. Are these smart investments for a risk-averse retiree?
Since 2003, the U.S. federal government has been pushing interest rates down. Remember, the principal value of bonds is pushed upward when market interest rates move downward.
Sadly, our government has chosen to break the backs of frugal savers by killing a reasonable interest rate return. Temporarily, millions of bond investors who hold investment-grade bonds have enjoyed substantial gains in their bond funds. But what will happen now? The Federal Reserve has reduced intra-bank lending rates to an inflation-weighted negative yield. Inflation is running between 3 percent and 10 percent per year, while interest rate yields have been artificially depressed to 2 percent for a 10-year U.S. government bond.
How long can the government keep a lid on long-term interest rates? Whenever market interest rates begin to rise, the principal value of all existing bonds and bond funds will fall. No one knows how high interest rates will rise and bond values will fall, but the risk of great loss is a certainty.
Using the old governmental CPI formulae, many cite 10 percent or more as the real inflation rate!
Market interest rates have been artificially depressed for an extraordinarily long time. It does not take a Nostradamus to predict that rates must rise during the next few years. When that happens, millions of seniors will be echoing Fern’s panic: “My statement shows that my principal has dropped!”
The interest income being paid on that bond will remain fixed, but the principal value Fluctuates. Fixed-income bonds are not risk-free. They can be an important part of a retirement portfolio, but you must understand that the principal value is not fixed; the income/interest is fixed for the entire term of the bond.
Next time: Inflation’s impact on traditional low yield “safe” systems.
If you’re ready to start getting your estate in order and secure your assets for the “worst-case” scenario, please give our office a call at 800-310-3100. Your first consultation is absolutely free. We’ll let you know what steps you need to take, right now, to protect you and your family. Call now.
Rick L. Law, Attorney, Estate Planner for Retirees.
Rick was named the #1 Illinois elder law estate planning attorney by Leading Lawyer Magazine. He has been quoted in the Wall Street Journal, AARP Magazine, TheStreet.com, and numerous newspapers and articles. Rick is the lead attorney for Law Elder Law, LLP, focusing in Estate Planning, Guardianship, and Nursing Home Solutions. His goal is to give retirees an informed edge when it comes to dealing with an uncertain future. Get flexible retirement strategies that work during good times and bad, plus information on how you can save your home and assets from being used to pay for long term care. Appointments available in Chicago, Aurora, Oak Brook, Schaumburg, and Joliet. Call 800-310-3100 for your free consultation now!
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