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How To Retire Happy, 7 Simple Steps To Creating Your Ideal Retirement
I'm going to address what I think is potentially the next big bubble that could burst on retirees.
In the late 90's we had the internet stock bubble, then we had the housing bubble that ended with a complete financial meltdown in 2008, could bonds be the next bubble to burst?
Back a few years ago you could earn 4 or 5% pretty easily in money markets or CD's. Now interest rates are near all time lows. Today, the 10 year treasury is under 2%.
What I wanted to do is share with you some of the potential risks I see with bonds right now.
The first is credit risk, or basically will I get my money back? Especially these days we need to be very careful about who is backing our bonds, and what their credit worthiness to repay us is.
What I really want to address, is interest rate risk.
Bond prices are inversely related to interest rates. Basically as interest rates go down bond prices go up, and when interest rates go up, bond prices go down. Kind of like a mechanical lever.
The concern here, is where interest rates are today. Again, we are at one of the lowest levels for interest rates in the last 100 years. So how much lower can interest rates go? Probably not much lower. At some point they are likely to start moving back up, and when that happens, bond prices will fall.
Not all bond prices will be affected equally. Just like a mechanical lever, we have some leverage going on here. Shorter term bonds are going to be less volatile than longer term bonds.
The best way to describe it is like this. Imagine that today you bought a bond for a $1,000 paying 4%, if tomorrow interest rates went up to 5%, first of all you'd be pretty bummed, but if you wanted to sell it could you? Of course you could. But no one is going to want to buy your bond for $1,000, when they can go out and buy a brand new one for $1,000 paying 5%. You will have to discount the price of your bond to make it equivalent to all the other new bonds that are out there.
If this was a bond that was going to mature next year, it's probably not that big of a deal. In a year you would get your money back and you would be able to go out and buy a bond potentially at the new higher rates. However, if it was a bond that wasn't going to mature for 25 or 30 years, that would be a big deal. You would be locked in at that lower rate for a long time, and so would whoever you decided to sell it to. So you would have to discount the price more on a longer term bond than you would on a shorter term bond.
Why am I talking about all of this?
Bonds have historically been a mainstay for a lot of retirees portfolios, but if we're not careful, we could be caught on the wrong side of the bond market.