Consider the following yield curves (thanks BondsOnline.com!).  They tell you what you can get as a coupon if you invest in bonds: municipal, Treasury, corporate, or just a plain old bank CD.  As you have no doubt noticed, these rates are a bit lower than you may have seen in the past…  Does this matter?  Does this require you to change your investment strategy?

Let’s find out.  Interest rate risk is what happens to your bond portfolio as interest rates change.  If the interest rates rise, your current bonds become less valuable.  If interest rates fall, the bonds in your portfolio become less valuable.  We’ve illustrated how much, by showing a collection of scenarios.  Imagine you bought $10,000 in bonds, either 5 year maturity, or 20 year.  Shortly after you buy them, interest rates either rise or fall to the given value on the top row.  Unrealistic, sure, but a good illustration of the range of motion for your bonds.  The below table (calculator used is here) gives you a risk/reward ratio for your bonds.

We assume you are invested in the treasury bonds, as the credit risk of corporates adds a whole dimension of fun I didn’t want to deal with yet…

Now which scenario is more likely? Looking at the chart above, I don’t see any cases where the 10 year bond (plotted in green above) ever gets down to 1%, let along .1%. But I do see plenty of 4% yields. I also see a respectable number of 6% yields. There’s enough there that if I had to bet, I would bet on the higher numbers over the lower numbers…

The scenario

Let’s make this concrete with a scenario. Assume we are doing some planning for Bob the Builder (that cartoon character…). He’s a 50 year old, married, and has exactly the median savings and income. To wit, he earns $63,000, and has a net worth of 120,000. He wants to make sure he earns enough of an income when he retires to make ends meet. We make the following assumptions:

• No social security.
• No deposits until he retires
• No reduction in spending, even after he retires.
• He retires at 70

The Baseline

We use firecalc.com, which is an amazing piece of software to determine what happens to him. Plugging those assumptions in, with the default weights, we get a 45% chance of him having money to live to 80. (the assumptions are 75% stocks, with the rest bonds)

Now we get to play with the numbers! We use FireCalc (http://www.firecalc.com) , which is the finest retirement planning programs I have ever seen, though I am not a retirement planner. It does Monte Carlo simulations to figure out what would have happened if you retired with the given assumptions. For instance, if you had started in 1974, right at the bottom of the nifty fifty crash, deposited your (inflation adjusted, in reverse, since we’re in the past) nest egg, and had it go up through your retirement, you would be enjoying one of the nice lines at the top (perhaps the purple one). The dot com crash would hurt, but since it’s near the end, you wouldn’t care much. Alternatively, imagine you started in 1929, right before the Great Depression. You would have lost tons of money right at the beginning, and would have had trouble making it up later. Plotting every one of those possible lines is a Monte Carlo simulation.

Maybe the stocks were the problem

So we put him in 45% long term treasuries, 45% corporate bonds, and 10% cash. Safest thing around, right?

I can safely tell you what will happen to him: he will run out of money.

What about dividend paying stocks?

How much income can we get from stocks?

Apparently we should look for stocks that yield between 2.5% and 7% (the green line). Returns include dividends, portfolios rebalanced weekly for precision. Trading costs have obviously been ignored. It’s clear that you can get wonderful returns with stocks, even while getting a steady income from your portfolio…