Investors typically have a choice between risk and return: If you want higher returns, you need to accept more risk or volatility in exchange. The same dynamics are true for income investments where greater yields often come with higher credit or interest rate risk. For example, junk bonds offer higher yields than Treasuries given their higher credit risk.
When building a portfolio, retirees must balance these risk factors with their income requirements. Bonds are often pitched as a sure-fire way to reduce risk and increase income, but they can be risky during low interest rate environments and turbulent times.
Let’s take a look at why bonds may be riskier than they appear on the surface, and how to find the right balance between income requirements and risk in your portfolio.
How Bonds Can Be Risky
Bonds are often pitched as a low-risk asset class given their low volatility and liquidity preference over equities. As a result, retirement portfolio allocations typically shift from stocks to bonds as investors seek more income and less volatility. Bond funds enable investors to easily shift asset allocations without having to deal with individual bonds.
Despite their reputation, there are a couple key risk factors to remember:
- Interest Rate Risks: The inverse relationship between interest rates and bond prices make low interest rate environments risky for bondholders. While lower bond prices aren’t important for investors holding until maturity, portfolios that hold bond funds could see significant value loss if interest rates move higher.
- Credit & Liquidity Risk: The COVID-19 pandemic has underscored the credit and liquidity risks facing the bond market. If the Federal Reserve hadn’t stepped in as a buyer of corporate bond ETFs, the market could have seen a significant contraction as credit quality deteriorated and buyers dried up.
These risks are exacerbated by the growing popularity of bond funds. For example, a bond that is downgraded to junk status might experience a sudden sell-off from a range of investment-grade bond funds. The selloff could result in fire sale prices for some bond issues, and consequently, steep losses for investment-grade bond funds.
Diversifying Risk Across Asset Classes
Your portfolio should reflect both your risk tolerance and income expectations. While bonds may provide more income than equities, over-allocating your portfolio to bonds could lead to significant risk concentration. Diversifying across different asset classes can help mitigate that risk that ensures that your portfolio has the right level of risk for your tolerance.
Some asset classes to consider include:
- Real Estate: Real estate investment trusts (REITs) hold a portfolio of real estate properties and tend to be uncorrelated with stocks, bonds and other conventional investments that investors may hold in their portfolios.
- Blue Chip Equities: Blue chip equities are large-cap companies that tend to be less volatile than other equity asset classes. In addition, equities tend to have an inverse correlation with bonds, making them a great diversification tool.
- Commodities: Commodities, such as gold or crude oil, can be a great way to diversify a portfolio away from just stocks or bonds. The downside is that these assets do not generate any income and capital gains may be limited.
- Private Equity: Accredited investors can participate in private equity deals or retail investors can purchase mutual funds with exposure to private companies. While these investments are higher risk, they can be a great diversification tool.
Diversification involves finding assets with prices that are not correlated with the rest of your portfolio. If one area of your portfolio underperforms, other parts of your portfolio may outperform and help lessen the blow to overall returns. The goal is to reduce risk in order to boost your overall risk-adjusted returns over time.
Strategies to Diversify Risk with Income
Risk tolerance must be balanced with income expectations when building your portfolio. While diversifying into equities may increase diversification, the decrease in allocation to bonds could translate to lower income in retirement. The good news is that there are several strategies that you can use to increase portfolio income and diversification.
Some popular income-generation strategies include:
- Selling Options: Covered calls and other option strategies can generate an income from a stock portfolio that’s above and beyond what’s possible with dividends. The only trade-off is typically less upside potential over time.
- Sector Focus: Some stock market sectors generate more income than others—such as utilities or energy pipelines. By investing in these sectors, you can generate greater levels of income while retaining exposure to equities rather than bonds.
- Real Estate: Real estate investments generate income from rents while still retaining the possibility for capital appreciation. In addition, some of these investments provide tax benefits for investors that further increase their attractiveness.
Snider Advisors’ Lattco Platform – Source: Snider Advisors
If you’re interested in generating income by selling options, the Snider Investment Method provides a done-for-you strategy to manage risk and maximize income. Snider Advisors’ Lattco platform includes a covered call screener that makes it easy to identify opportunities and build out a portfolio while only making a handful of trades each month.
The Bottom Line
Investors always have a choice between risk and return—and these same principles apply to income generation. When balancing risk with income requirements, it’s helpful to seek out the right asset allocation (e.g., stocks versus bonds) and identify subsets of each asset class that generate the most income to meet your retirement goals.
If you’re interested in generating income from stock options, try our free e-courses to learn how to build the right strategy. If you’re looking for a hands-off approach, contact us to learn more about our asset management solutions.