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Fixed income’s role in saving for retirement

Mike Shafai //July 25, 2011//

Fixed income’s role in saving for retirement

Mike Shafai //July 25, 2011//

Every investor’s financial situation and investment goals are unique and evolve over time. As investors approach retirement, funding living expenses becomes an increasingly significant consideration.

For many investors, maintaining a steady income stream is a focus for their retirement years. Customizing your portfolio to include fixed income securities may help achieve this goal. Fixed income securities whose interest income is taxable as regular income may be suitable for tax-deferred retirement accounts.

How are your Assets Allocated?

Asset allocation is an important step in saving and planning for retirement. Asset allocation describes the distribution of an investor’s financial assets across different investment categories, or asset classes. The major financial asset classes are stocks (equity), bonds (fixed income) and cash. Your risk tolerance, financial goals, and time horizon are key inputs to determine what portion of your assets you allocate to fixed income securities. Many investors seeking to generate a steady income stream in retirement invest a proportion of their portfolio in bonds.

What is a Bond?

Bonds are debt obligations issued by governments, agencies and corporations. The issuer promises to repay principal in full at the bond’s maturity, and to pay periodic interest income at a specified interest rate over the life of the bond. Typically, bond investors can anticipate regular cash flows from interest and principal payments. The variety of bond issuers and maturities available provides flexibility for investors to build a bond portfolio to match their investment needs.

Bonds are often used as an important component of a balanced portfolio. Through the diverse fixed income market, you can choose individual securities based on your specific investment goals and level of risk tolerance. Issuers such as the US government and corporate entities allow diversification across industrial sectors and credit quality, while different maturity structures-from 1 year to 30 years-provide the ability to match securities to your financial time frame.

Subject to the issuer’s credit risk, investors can expect to receive a steady stream of interest income, usually on a semiannual basis, until the bond matures. Including fixed income securities in your portfolio, as well as other asset classes such as equities, can potentially provide greater diversification than concentration of assets within one asset class, potentially allowing you to reduce the risk in your portfolio without significantly sacrificing return. However, diversification and asset allocation do not ensure a profit or protect against a loss in declining markets.

Structuring your Bond Portfolio

If you are saving for retirement you may want to consider implementing a laddered portfolio strategy. A laddered strategy involves diversifying your holdings across short-, intermediate-, and long-term fixed income securities. This strategy takes advantage of the higher liquidity of shorter-term securities while also attaining the higher returns typically available through longer-term securities. In addition, a laddered portfolio may provide a predictable flow of interest income and a level of price stability during turbulent interest rate cycles.

Consider the Risks Involved

Before you invest, remember that all fixed income securities are subject to risks that you should consider. In particular, bond prices are susceptible to interest rate fluctuations; generally, if interest rates fall, bond prices rise and, inversely, if interest rates rise, bond prices fall. Another point to remember: If you hold your bonds to maturity, your principal will be returned in full, but, if you sell your bonds prior to maturity the price you receive may be more or less than your original purchase price or maturity value.

You should also consider the credit quality of the bond: If an issuer is unable to meet its financial obligations it may fail to make interest and principal repayments. Investment grade bonds (those rated ‘Aaa/AAA/AAA’ through ‘Baa/BBB/BBB’ by Moody’s Investors Service, Standard & Poor’s and Fitch, respectively) may be more suitable investments for conservative investors. Reinvestment risk may impact your portfolio. This is the risk that the cash flows from a given investment will be reinvested at a lower rate of return. This is especially evident during periods of falling interest rates, when coupon and principal payments are often reinvested at a lower yield than the original instrument.

Not all bonds, e.g. municipal bonds, are suitable for use in tax-deferred retirement accounts and you should be sure to discuss your fixed income retirement investment strategy with your tax or legal advisor.

Achieving your Investment Goals

Your investment goals and needs are unique. Regardless of your individual financial goals, the wide variety of choices in the fixed income market allows a tailored strategy to help address your specific requirements. Your Financial Advisor can work with you to help determine the right fixed income investments for your portfolio.
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Mike Shafai is Vice President, Financial Advisor with The Pikes Peak Group of Morgan Stanley Smith Barney in Colorado Springs. He can be reached 719-577-6324 or toll free at 800-225-1163, or you can email him at [email protected].