The Case For Investing in Bonds During Retirement

Abstract

For households seeking retirement income security, short-term deposits (such as money market accounts, certificates of deposit, and Treasury bills) seem an ideal and appropriate investment choice – particularly given the recent extraordinary turbulence in the financial markets. Over the past year, an investment in short-term deposits would have actually outperformed investments in corporate bonds and far outperformed corporate stocks. Retired households exhibit a strong preference for holding such apparently safe investments. One study found that 86 percent of households nearing retirement (ages 60-64) had bank accounts, while only 33 percent owned stocks directly and only 7 percent owned bonds directly. And the desire for short-term investments increased with age. But short-term investments, while safe, produce uncertain returns. This Issue in Brief highlights the trade-off that households must make between a guaranteed return of capital and a guaranteed return on capital – they cannot have both at the same time. Short-term deposits provide a guaranteed return of capital, but offer no guarantees as to the return the household will receive on its capital. In contrast, a portfolio of Treasury bonds of appropriate maturities provides a guaranteed return on capital, but with the return of capital guaranteed only at maturity. This brief argues that retired households seeking a secure and dependable income should prioritize return on capital over return of capital. For such households, the true risk-free asset is a portfolio of bonds and, in particular, inflation-protected bonds of appropriate maturities.