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Wednesday 10 April 2024 by Christian Crew Education (basics)

How bonds can help you retire with a stable income

Whether you're thinking of the ideal retirement, planning for retirement, or have retired, we have put together this article to help you understand the role bonds play in retiring with a passive income.

How much do you need to retire comfortably?

Determining your ideal retirement amount in Australia hinges on various factors: your lifestyle choices, future plans, anticipated duration of retirement, and your existing financial status, including salary earnings, superannuation balance, and assets. Crafting a detailed budget is crucial, encompassing current expenses, future adjustments, and the value of savings across cash, superannuation, and investments. Online retirement calculators, often free, offer valuable insights when planning, accessible through a simple search.

The Association of Superannuation Funds of Australia (ASFA) provides annual financial estimates for retirees around 65 who own homes and are in good health. These figures outline the annual amounts required for different retirement lifestyles: $70,806.43 for a comfortable lifestyle for couples and $50,207.02 for singles; $45,946.62 for a modest lifestyle for couples and $31,867.31 for singles. A comfortable lifestyle permits broader leisure activities, domestic and occasional international travel, and a good standard of living.

While a rule of thumb suggests around 67% of pre-retirement income sustains current living standards, the exact retirement fund depends on personal circumstances, desires, and expectations. Considerations include spending habits, hobbies, and debt status. Factoring life expectancy is vital, ensuring financial adequacy for post-work years, considering rising life expectancies and potential retirement durations of up to 35 years. Planning for longevity is crucial, incorporating healthcare costs and lifestyle maintenance into retirement income requirements.

The chart below demonstrates these probabilities. For instance:

A 65-year-old woman who is a non-smoker and in good health has a 72% probability of living to the age of 85. However, if she were a smoker and not in excellent health, this probability decreases to 57%.

For a man in excellent health and a non-smoker, the probability of reaching the age of 90 stands at 43%. Contrastingly, if he is a smoker and not in excellent health, this probability drops to 24%.

In the case of a couple, if both partners are non-smokers and in excellent health, there is a 46% probability of them reaching the age of 95. Conversely, if they are smokers and not in excellent health, this probability decreases to 21%.

These figures underscore the importance of considering these factors when planning for retirement.

Source: J.P. Morgan

Why consider Bonds for your retirement income?

Ensuring a stable income during retirement isn't just a luxury, it's crucial for maintaining your desired lifestyle and covering everyday expenses without financial stress. While your job may have provided reliable income during your working years, retirement demands a consistent income source unaffected by market fluctuations. Corporate bonds, issued by reputable companies like Commonwealth Bank and Woolworths, offer precisely that —a dependable and predictable income stream due to their investment-grade rating and lower risk and volatility compared to other asset classes.

In retirement planning, bonds should be a cornerstone investment, providing regular interest payments and returning your principal investment at maturity. This stability forms the bedrock of a passive cash flow strategy, allowing retirees to sustain their lifestyle and meet essential expenses regardless of market volatility.

Without this reliable income source, retirees may face the risk of depleting savings or taking on debt, leading to financial strain and anxiety. For instance, a retiree with a $1 million portfolio seeking an annual income of $50,000 could achieve this through investing in a portfolio of 10-year investment-grade corporate bonds with an average yield of 6%, generating a stable $60,000 income surpassing their needs.

What are Bonds?

Bonds represent loans made by investors to governments or corporations, with the issuer agreeing to pay interest over a specified period. Investment-grade corporate bonds, backed by strong credit ratings, are considered relatively low-risk assets, playing a significant role in financial markets, particularly for retirees seeking income and capital preservation. Corporate bonds come in various forms, including fixed-rate, floating-rate, and inflation-linked bonds.

Fixed-rate bonds offer retirees a steady income stream with a predetermined interest rate remaining constant throughout the bond's life. These bonds provide stability, regular interest payments, and return of principal upon maturity, ensuring retirees can cover living expenses comfortably. Floating-rate bonds, on the other hand, adjust interest rates periodically, often tied to benchmark rates like the RBA 90-day Bank Bill Swap Rate, offering protection against rising interest rates and inflation, thereby preserving purchasing power. Meanwhile, inflation-linked bonds adjust interest payments and principal based on inflation indices like the Consumer Price Index, safeguarding retirees against the erosive effects of inflation and ensuring a comfortable retirement lifestyle.

How Bond returns compare to shares

In the current environment, where inflation is high and interest rates are rising, corporate bonds can offer a number of advantages over other asset classes. For example, cash and Australian government bond returns are more likely to be eroded by inflation, while shares are more volatile and can be riskier in a rising interest rate environment and in times of geopolitical risk.

Corporate bonds, on the other hand, can offer a higher return than cash and Australian government bonds while also being less risky than shares. This makes them an attractive option for investors who are looking for income and diversification.

In a typical environment we would expect share dividends to outperform investment-grade bonds, but in an environment with interest rates at multi-year highs, we are experiencing a rare and unique environment when investors can invest in corporate bonds, which offer greater stability and less risk than shares while offering greater returns. 

Source: Reserve Bank of Australia – 25-year interest rates 

If we consider the table below, we can see Investment-grade corporate bonds are currently outperforming share dividends and term deposits. Corporate bond yields are at multi-year highs. Now is a fantastic time to consider investing in bonds to provide income for your retirement.

For investors seeking solid levels of income from their assets, something of a regime shift occurred in the last couple of weeks of October 2023. For the first time in more than a decade, the yield on bonds (green line) exceeded that of equities (dark blue line), as per the below chart.

Many retirees utilise Australian large-cap equities as a key source of income, and in the days of near-zero interest rates, it was not hard to understand why (particularly once factoring in franking credits). However, at this juncture, investors have an opportunity to de-risk their portfolios and lock in higher income in a ‘structurally senior’ asset class.

As can be seen from the chart above, it is not often that these yields are aligned, and we would not expect this to stay the case for an extended period. The reason for this is simple – each of these instruments offer a differing level of risk (and liquidity), and most of the time, this is reflected in appropriate pricing differentials.

The reason why the asset allocation switch from equities to bonds is compelling is because of the structural difference between a coupon and a dividend. A coupon is a contractual payment that needs to be paid, otherwise creditors have the capacity to appoint administrators to wind up a company. It is not a discretionary payment (other than for limited instruments, such as additional Tier 1 hybrid securities), and the consequences can be fatal (in a corporate sense) if a coupon or bond principal is not repaid on time.

A dividend, however, is a totally discretionary payment that is up to the board to declare (and, for some companies, subject to third-party approvals). Dividends are typically funded from the net profit a company generates, i.e. after it has paid all of its taxes, employees and interest costs. Importantly, these interest costs include the bond coupons mentioned above. If the business runs into a tough spot (or if any expenses increase on account of inflation), the board will likely lower or cancel the dividend for that period in order to retain capital within the business. This would likely be considered a prudent course of action, although investors who are accustomed to dividends funding their retirements may not take such a rosy view of the situation.

Ways to Invest in Corporate Bonds

There are two main ways Australian investors can directly buy bonds, which include purchasing them Over-The-Counter (OTC) or via the Australian Securities Exchange (ASX). They can also be bought indirectly through a bond-themed Fund or ETF.

In Australia, the OTC bond market is where the vast majority of bonds are bought and sold; it’s where 95% of bonds are traded. In fact, the Australian bond market has approximately $2.1 trillion in bonds outstanding – larger than the ASX. With Bonds traded on the ASX, you can invest with just a few hundred dollars. However, you will be limited to just a small group of issuers which are typically hybrids and carry additional risk.

To buy and sell bonds in the OTC market, you need a fixed income dealer like FIIG. Historically, to buy corporate bonds, investors were restricted to $500,000 parcels, but with FIIG’s small parcel trading service, both retail and wholesale investors can buy and sell bonds in parcels from $10,000 with a minimum portfolio balance of $50,000.

Now, hundreds of bonds are accessible to private investors with over 600+ options from well-known names, including Ampol, Transurban, ANZ and many more, and they include AUD, USD, and GBP Bonds. Investors can choose from sample portfolios or hand-select the bonds to suit their individual investment needs.

For further details please consider downloading our free, no obligation ‘How to retire with passive income’ guide.

How to Retire with Passive Income - the Role of Bonds In a Retirees Income Portfolio (