Displaying items by tag: income
Are Fixed Indexed Annuities Better Than Bonds?
Traditionally, fixed income is where financial advisors look to reduce portfolio risk. This is no longer the case in the post-pandemic period, as the bond market has experienced major volatility, which is becoming the norm in a high-rate, high-inflation regime.
Given these conditions, investors may be better off with fixed index annuities (FIAs). Like bonds, FIAs produce income; however, a key difference is that FIAs guarantee an income stream for life as opposed to a fixed period. Another advantage of FIAs is that they have higher earnings potential than bonds, given that many are designed to earn interest based on the performance of an external index like the S&P 500. In contrast, fixed income has significantly underperformed over the last 5 years and failed to beat inflation.
Over long periods of time, costs matter when it comes to long-term investing. Most bond investments have fees that range between 0.5% and 2%. In contrast, FIAs tend to have much lower fees, on average.
In terms of risk, FIA offers full protection of the principal investment. This means that it can be more effective than fixed income to hedge equities, especially in the current environment. Overall, FIAs can be more effective than fixed income, especially for investors who are in or nearing retirement.
Finsum: Advisors should consider fixed indexed annuities (FIAs) as an alternative to fixed income, especially in the current environment. FIAs offer lower costs, more downside protection, and greater potential for appreciation.
The Case for Increasing Fixed Income Allocation: Goldman Sachs
According to Lindsay Rosner, the managing director of multi-sector fixed income investments at Goldman Sachs, fixed income is presenting investors with an attractive opportunity to lock in high yields without compromising on quality. There are some challenges given divergences in central bank policy around the world and increasing uncertainty about the timing and direction of the Fed’s next move. Overall, the firm believes that the status quo of ‘higher for longer’ is likely to prevail.
A major factor is inflation, and the economy proving to be more resilient than expected. As a result, the market is now expecting two quarter-point rate cuts before the end of the year, compared to expectations of 150 basis points in cuts entering the year. The next Fed decision is on July 29. Prior to that meeting, there will be considerable amounts of inflation and labor market data, which could impact its thinking, although the current expectation is for it to hold rates steady.
With rates at these levels, there is increased risk that consumer spending is affected or that a higher cost of capital begins to impact corporate profitability and hiring. This risk increases the attractiveness of fixed income, especially as many investors are looking to rebalance given strong equity performance. Rosner sees opportunity in higher-quality areas such as investment-grade corporate bonds and structured products with AAA or AA ratings, especially given an impressive carry differential over Treasuries.
Finsum: Goldman Sachs sees opportunity in higher-quality segments of the fixed-income market. It believes investors should lock in yields at these levels, given the risk that high rates will eventually sour the economic outlook.
Robust Economy Threatens Soft Landing: Vanguard
In its Q2 active fixed income commentary, Vanguard discussed lowering rate hike expectations for 2024 due to strong economic data, while inflation remains stubbornly above the Fed’s desired levels.
Despite the odds of a soft landing declining, Vanguard’s base-case scenario is that the Fed is done hiking and will hold rates at these levels until later this year. A risk to the firm’s outlook is inflation lingering above 3%, which would spark discussion about the need for further rate hikes.
It sees monetary policy as remaining data-dependent and notes that the Fed has limited room to maneuver. The central bank risks another surge in inflation by cutting rates too soon, but it also risks a prolonged recession by cutting rates too late.
Despite this uncertainty, Vanguard believes that there will be opportunities amid higher market volatility. It recommends investors take advantage of locking in attractive yields for longer durations and sees potential for better risk-adjusted returns in bonds vs. equities. Over the next 5 years, Vanguard forecasts returns of 4.5% for stocks and 4.3% for bonds. However, bonds are expected to have one-third of the volatility of stocks at 5.2% vs. 15.8%.
Finsum: Vanguard shared its quarterly active fixed income outlook. The firm is downgrading its expectations for rate cuts in 2024, given recent economic data. Instead, it sees more opportunities in other parts of the fixed-income market.
Fixed Income Sector Thriving
2024 has proven to be a year of relentless volatility for fixed income, given mixed signals about inflation, the economy, and monetary policy. However, there are plenty of opportunities to make money amid these conditions.
A consequence of high rates is that the US government is expected to pay more than $1 trillion in interest to bondholders this year, which is more than double the average from the previous decade. Currently, all Treasury securities are yielding more than 4%, and due to elevated rates, investors have a higher margin of safety. This means that fixed income is once again a source of meaningful income for investors and serves as a counterweight to equities.
Deal flow also remains robust, which is a positive for underwriters and sponsors. According to Bloomberg, bankers who underwrite bond offerings are expected to see a 25% increase in bonuses. In terms of sales and trading, bonuses are expected to rise by 20%, compared to an increase of 5% to 15% for equities.
Another trend in fixed income is the electronication of the bond market. Traditionally, bond trading has been done over the phone or through banks, which has resulted in illiquidity and less price discovery.
Now, volume is moving to electronic bond exchanges, which is benefiting market makers like Citadel Securities and Jane Street. These firms are now making markets in government and corporate bonds. It’s estimated that 42% of investment-grade debt trades were electronic last year, compared to 31% in 2021.
Finsum: Entering the year, many were confident that Fed rate cuts would fuel a bull market in bonds. This has failed to materialize, but there have been opportunities in fixed income.
Is the 4% Rule Still Relevant?
The 4% rule has become conventional wisdom when it comes to managing finances during retirement. As millions of people enter retirement over the next decade, it may be time to revise this rule, given higher inflation and longer lifespans.
Social Security benefits are typically equivalent to 40% of a retiree’s income. According to TIAA, retirees should consider pairing the 4% rule with an annuity to generate higher levels of income during retirement. This means that a retiree would convert some portion of their savings into an annuity.
In the first year, this is likely to boost income by up to 32% compared to just using the 4% rule. It also leads to more predictable income and shields retirees from market risk. More predictability can also help with more effective financial planning, leading to a more enjoyable retirement.
Treasury Inflation Protection Securities (TIPS) are another method to increase guaranteed income, especially with a ladder across different maturities. It also protects retirees against inflation.
Overall, the 4% rule should be reconsidered, especially in this era. It leads to less spending flexibility and should be augmented with other sources of income. It also doesn’t account for retirees’ individual circumstances, such as tax rates, risk profiles, and cash flow needs.
Finsum: TIAA believes that the 4% rule should be reconsidered, especially for those retiring now. Retirees may need more income and should consider annuities or TIPS.