Junk-Bond Yields Don’t Provide Much of a Cushion Against Inflation

Junk-bonds’ power to beat inflation is fading — the gap between them has shrunk to a three-decade low of just 0.75%.

Yet another setback for retirees who view traditional fixed-income investments as a secure way to fund a long retirement.

The gap between yields on junk bonds and the annualized two-year rate of inflation is the smallest level ever — just 0.75% — in data going back three decades. (N.B.: Horizon is using a two-year inflation rate to smooth out the retreats and rallies that occur during recessions and recoveries.)

As the chart below shows, the more significant change in the last year is new lows for yields on junk-bonds, rather than a paradigm shift for inflation, despite recent high readings for the Consumer Price Index as the economy reopens.

What’s disconcerting for retirees, in our view, is that the yield on junk bonds has dropped under 5%. A yield below that level was the rare exception over the last three decades. However, since November 2020, yields are holding below 5%, and recently breached 4%.

The practical effect on a retiree is that the riskiest sub-set of bonds — following in the footsteps of Treasuries and investment-grade corporate bonds — are no longer providing a comfortable cushion over the medium-term rate of inflation, which could impair their spending plans.

Why are yields dropping? We believe it’s because of the reach-for-yield by fixed-income investors around the world, who are running out of places to find positive, inflation-adjusted returns. That behavior is being spurred by the Federal Reserve’s zero interest rate policy and the low-rate policies of the other major central banks.

Further compression of bond-market yields likely means a further depression of inflation-adjusted, returns.

(See Horizon’s Q1 Focus feature article, “Crushed by Zero,” about the difficulties and potential solutions for investing in a zero-interest rate world.)

Horizon believes that financial advisors who embrace goals-based financial planning can assist retirees in making decisions that can reduce longevity and short-fall risks — risks that could increase if a retiree’s portfolio is too reliant on fixed-income. Our research paper on retirement investing and risks details our view of the issue.

As goals-based investors, we believe that bond-market alternatives, a larger tilt towards equities, and incorporating a risk-mitigation overlay are what retirees and their advisors may want to consider to help ensure a nest egg remains well-funded during what could be a long retirement. See our Real Spend® web page for details about Horizon’s goals-based distribution strategy, which is aimed at increasing the probability that a client’s money will be there for them during a long retirement.

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