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What Rising Yields Mean for Your Retirement

What's happening and what can you do?

Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar. Many factors have contributed to the downturn we've experienced in the stock and bond markets in 2022. But in particular, concerns about rising interest rates have certainly taken their toll. Joining me to discuss the implications of rising yields for retirement portfolios is Christine Benz. She is director of personal finance and retirement planning for Morningstar.

Hi, Christine. Good to see you.

Christine Benz: Hi, Susan. Good to see you.

Dziubinski: Christine, let's talk a little bit at the start about what's been going on with interest rates this year. The Fed has raised rates a couple of times already. What's been driving that? What's going on?

Benz: Right. The Fed, first and foremost, is responding to inflation, which has been pretty hard to ignore. Even though we've seen the numbers come down a very little bit very recently, inflation is still really very high, and the Fed is thinking that if it does increase borrowing costs, that could put a damper on demand. So, it's really that simple, that's the Fed's goal. But it has had repercussions for financial instruments, that's for sure.

Dziubinski: Now, when it comes to retirees in particular, retirees very often do hold some portion of their portfolio in bonds. So, let's talk a little bit about how rising yields have affected bond investors this year. How bad has it been?

Benz: Before we get into the specifics, just to talk about why when interest rates go up that hurts bonds. The basic idea is that if I have a bond with a yield attached to it, an older bond, and I know that newer bonds are coming online, and other market participants know that newer bonds with higher yields are coming online, they're going to say, "Well, I don't want that bond. I'm going to mark down the price of that bond because I know that there will be higher yields," and that's the fact of holding bonds is that prices are affected by yields. So, when yields go down, bond prices go up and vice versa. What we've been seeing so far this year is this downward pressure on bond prices.

And when we look across mutual funds, we see that certainly they've been affected. So, short-term bond funds through early to mid-May are down about 3% or 4% on average. Intermediate-term funds, which have more interest-rate sensitivity, have been much more affected. Losses are in the realm of 10% so far this year. One thing investors have said is, "Well, forget bond funds in this environment. Instead, I'm just going to own individual bonds and hold them to maturity." And that's true that if you do that, you won't be affected by these price changes. On the other hand, that can get a little bit complicated to build a portfolio of individual bonds. It's a trade-off, I would say, for investors. But bond-fund investors have definitely incurred some losses so far this year.

Dziubinski: And that can be tough for retirees who very often think of the bond portion of their portfolio as their safer assets. How could a retiree go about doing some bond-fund audit in his or her portfolio to make sure that they're really in the right types of bond funds given today's climate?

Benz: Yeah, I think that's a super worthwhile exercise. Ideally, you would have been doing this along the way. But I do think it's important to think that if you have spending needs that you expect to have to cover within the next couple of years, you probably shouldn't be in bonds, even high-quality short-term bonds, because you want to keep your principal values stable. You're probably better off just holding cash for those very short-term goals. Even though inflation will erode the purchasing power of your cash, it's probably the lesser of the two evils.

On the other hand, I think, if you have a time horizon of, say, three to five years for a goal, I think that you can reasonably be in short-term bonds. You'll have a little bit of price dislocation as interest rates increase, but you will have a higher yield that you'll be able to take advantage of. So, I think a short-term bond fund can make sense for time horizons in that ballpark. And then, if you have a time horizon of, say, five to 10 years, I think intermediate-term bonds can make sense. They have higher yields than short-term bonds and, certainly, higher yields than cash, but they will have more price-related volatility. So, if you hold them, you'd want to have that longer time horizon in mind.

Dziubinski: Now, annuities are another type of investment that can often benefit in a rising rate environment. Talk a little bit about that.

Benz: That's right, Susan. All else being equal, we should see annuity payouts rise because insurers, if they take in people's funds who are buying annuities, they have to invest them somewhere. And that in turn determines the payout that you receive as an annuity purchaser. I think we will see some positive effects for annuities. It's been a long dark night for the very basic annuity types where payouts have remained very, very low, but I think we will start to see them pick up with interest rates.

The headwind, which we've talked about before, is inflation—the very basic annuity types have fixed payouts, and your purchasing power will be eroded by inflation. So, that's a trade-off: Even as higher yields should be good for annuity purchasers, inflation could somewhat reduce their appeal.

Dziubinski: And now, let's look at the other side of the ledger for retirees who perhaps still have some debt. How should they be thinking about this rising-rate scenario?

Benz: Right. And we do see that, increasingly, retirees are coming into retirement with debt, oftentimes mortgage debt, sometimes student loan debt, somewhat surprisingly, either their own student loan debt or their children's student loan debt. And so, if we are seeing higher borrowing costs, which we are, that would tend to make a strong case for paying off that debt as soon as possible. If you're a mortgage holder with a fixed-rate mortgage, of course, you're not going to be affected by higher interest rates. But certainly, if you have some sort of a loan with a variable rate, that argues for accelerating those payments because that loan will become more costly for you over time.

Dziubinski: Christine, thanks for your time today, for giving us a little bit of perspective about what rising yields mean for retirees. We appreciate your time.

Benz: Thank you so much, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.