Bond Ladders

[chinaco]

I am FIRE planning.

I am considering our options for managing a stable payout (income stream).

Right now I am using Bond Mutual Funds.

I have been considering the upside/downside of using a bond ladder.

I am considering splitting the approach... bond ladder and mutual fund.

I am so confussssssssssssssed!


I am hoping I can leverage your experience

If you know of a good source of information that shows the trade-off between options... please share it.

If you gone through this yourself and decided to use a ladder or not use a ladder, please share why you decided one way or the others.

Like all retirement management decision... it is more complicated than one would expect.

 

[freebird5825]

Disclaimer: I am an Engineer and by no means any sort of expert. I will simply describe my approach.

My age: 52
Status: FIREd with COLA'd survivor pension and fixed annuity for income

History of bond investments:
1996-97 - EE bonds purchased for 13 consecutive months
1997 to present - Balanced VG mutual funds containing corporates and other critters I have no clue about selecting in individual issues
2004-6 - low denomination I bonds, purchased for 33 consecutive months
1997 to present - built up a large stake in national TE munis via VWAHX, then VWALX*. Still DCAing into this fund at a slower rate than during the principal buildup period.
2009 - followed the "pssst Wellesley" advice found here during a consolidation of some "dog" mutual funds with expense ratios only a beginner would pay

Result: Full diversification of bond portion of retirement portfolio.

* The VWALX fund is the "OMG my furnace died" or the "Inflation just killed me" backup mechanism for me. It remains untouched at present. Every 30 days I am receiving some very nice TE dividends, all reinvested.

 

[chinaco]

Disclaimer: I am an Engineer and by no means any sort of expert. I will simply describe my approach.

...

Thanks.

It looks like you are covering many bases. What factored into your decision for the approach.

That is where I struggle.

I suppose I am still trying to figure out which part of the overall problem I might solve using a ladder... or if I should even use one.


For example. Should I use a ladder to fund long-term base income for DW and I (to fill the gap after pension and SS source). Use something like Tips or Treasury notes. Invest the rest in conventional mutual funds of stock and bonds.

 

[kaneohe]

see here for more: bond ladders vs mutual funds - Google Search

ladders:
Pro: principal mostly guaranteed wrt interest rate risk provided you wait to redeem at maturity .
Con: diversification may be problem unless ladder is large; purchase may require some knowlege of specific bonds unless buying Treasury type( wrt company/municipal risk); purchase/redemption costs may be high unless ladder is large or held to maturity

funds:
Pro: easier "instant" diversification
Con: Principal can fluctuate tho reinvestment of dividends can help level this out (dividend buys more when value drops); more complex record keeping if reinvest dividends;

 

[Independent]

T
For example. Should I use a ladder to fund long-term base income for DW and I (to fill the gap after pension and SS source). Use something like Tips or Treasury notes. Invest the rest in conventional mutual funds of stock and bonds.

That makes sense to me. You are connecting certain types of assets to certain needs. I think that helps conceptually at least. In our case, we can cover base income entirely with SS by deferring SS to 70. So we don't need any other assets to cover the long term base income need. We have CDs, TIPS, and a fixed interest IRA to cover the period from retirement to 70.

OTOH, I know that some people would say it's best to keep everything in one big pot with a reasonable AA, then withdraw to maintain the AA. I expect that works if you've got enough money that you can cover your needs even when the market is down.

I've never seen a calculation that compares them. The complication is that if you get conservative to cover your base income, it seems plausible that you can be aggressive with your excess.

I agree with the prior post that funds vs. ladder is basically market value risk vs. lack-of-diversification risk. I don't have any insights on that. Our TIPS are in a fund mainly because it was easy to buy. I've reasoned that the market value risk on TIPS must be less than on nominal bonds because nominals are subject to fluctuations in both real returns and inflation, while TIPS are only subject to fluctuations in real returns. But I don't have any expert support for that - we don't have enough TIPS history to prove it works.

 

[FIREd]

I use bond funds for bonds with a credit risk (munis, corporates, etc...).

I use individual bonds for bonds with no credit risk (treasuries, TIPS, i-Bonds, CDs).

Note: I am partial to individual TIPS vs. TIPS funds because I consider my TIPS ladder a CPI-adjusted SPIA. The income the ladder produced rises and falls in unison with CPI. Not so with VIPSX for example.

 

[FIRE'd@51]

I've reasoned that the market value risk on TIPS must be less than on nominal bonds because nominals are subject to fluctuations in both real returns and inflation, while TIPS are only subject to fluctuations in real returns.

While you are correct that the TIPS price is (theoretically) only sensitive to changes in real rates, this price sensitivity is typically considerably larger than that of nominal bonds of the same maturity, because TIPS have a lower interest rate (and hence a higher duration).

 

[haha]

While you are correct that the TIPS price is (theoretically) only sensitive to changes in real rates, this price sensitivity is typically considerably larger than that of nominal bonds of the same maturity, because TIPS have a lower interest rate (and hence a higher duration).

Clever point.

Ha

 

[GregLee]

I bought some discounted bonds in the late 70s when interest rates were 15-20%. I was just following basic advice given to novice investors -- buy bonds if you think interest rates will fall. Those bonds did quite well. So, should you buy bonds? Do you think interest rates will fall?

 

[chinaco]

I bought some discounted bonds in the late 70s when interest rates were 15-20%. I was just following basic advice given to novice investors -- buy bonds if you think interest rates will fall. Those bonds did quite well. So, should you buy bonds? Do you think interest rates will fall?

I understand that basic relationship.

I agree... this is an important consideration.

While optimizing gain and minimizing expense (and hassle) is important to me.

I am more focused considering how I might use such a mechanism to transport money (beat inflation) in to the future as a rock solid reliable source of income. In that sense, I would setup the ladder based on the bond maturing and the return of principal (as oppose to taking the gains). Although... if the gain were big enough I might sell

On the interest rate front... I am interested in the coupon because I want as much return for my investment as possible.... so I am unlikely to begin constructing a ladder today.

The other option I have considered is buying a SPIA... which I would not buy today for the same reason.

 

[GregLee]

... transport money (beat inflation) in to the future as a rock solid reliable source of income.

If you want a check (or automatic transfer) to come in every month, I believe you can arrange that with a mutual common stock fund. You don't have to invest in interest producing securities.

 

[kcowan]

I think it boils down to the amount of money you have to invest. If less than $100k then go with funds, between $100k and $500K, it depends on you and your aptitude. Over $500k, definitely take the time to build a bond ladder. You will have enough diversity to make it worthwhile.

I did a bond ladder for MIL and it was under $500K. It was a lot of work but also a learning experience. I reduced her annual fee from over $9k to under $1k.

 

[GusLevy]

While you are correct that the TIPS price is (theoretically) only sensitive to changes in real rates, this price sensitivity is typically considerably larger than that of nominal bonds of the same maturity, because TIPS have a lower interest rate (and hence a higher duration).

This conclusion is incorrect. Theoretically the argument can be made that Macaulay or modified durations for Tips can be greater than Nominals due to the lower initial yield but since TIPS have the embedded call option on future inflation the mathematical duration calculations are irrelevant to TIPS since future cash flows are unknown. Most traders/portfolio mgrs will go further based on observed price volatility of TIPS thus far in their short history to utilize effective duration for TIPS that are still modified by multiplying by a basis risk factor which further reduces the actually used duration for TIPS.

A strong argument can me made that TIPS have no practical ability to be used for duration management at all. Since an investor needs duration for predictive value in case interest rates change, the fact that most of TIPS' price volatility is determined by the Market's expectation of inflation rather than the actual change in interest rates creates the dilemma. To me, the ultimate answer will be solved when some genius is able to create a risk measure for real yields that is the parallel to the spread duration risk which is used for credit risk: If successful, that individual will make a lot of money at a hedge fund...or as a consolation prize will win the Nobel Prize.

Anyway, try this mental exercise: Imagine that the G20 meetings in Korea are a disaster and that all-out currency wars break out which is highlighted with the USD no longer accepted as the world's currency reserve. Both inflation expectations and interest rates scream higher as a result. Nominals would get destroyed but comparable TIPS may not perform too badly since the expected higher inflation would drive their bids higher: This creates the situation which TIPS have proven to do so in the past of having very low duration or even negative duration.

 

[friar1610]

I have not read every post in this thread, so I may have missed something.

I (we) have a three-fold approach to fixed income:
- Vanguard Total Bond Market Fund.
- A bunch of I-Bonds, most of which I was fortunate enough to buy when the fixed rate was 3.5%.
- A ladder consisting of Treasury bonds, CD's and TIPS. In terms of the ladder, I don't distinguish between the different vehicles, only when they mature.

At one time I put the I-Bonds into the ladder (and gave them nominal maturity dates which I could extend at any time I wanted to since they are good for 30 years.) But I eventually put them in a different pot and now have the ladder built primarily from CD's but including a few TIPS and non-TIPs Treasuries. I don't distinguish between bonds and CDs in that they are all fixed income.

 

[FIRE'd@51]

This conclusion is incorrect. Theoretically the argument can be made that Macaulay or modified durations for Tips can be greater than Nominals due to the lower initial yield but since TIPS have the embedded call option on future inflation the mathematical duration calculations are irrelevant to TIPS since future cash flows are unknown. Most traders/portfolio mgrs will go further based on observed price volatility of TIPS thus far in their short history to utilize effective duration for TIPS that are still modified by multiplying by a basis risk factor which further reduces the actually used duration for TIPS.

A strong argument can me made that TIPS have no practical ability to be used for duration management at all. Since an investor needs duration for predictive value in case interest rates change, the fact that most of TIPS' price volatility is determined by the Market's expectation of inflation rather than the actual change in interest rates creates the dilemma. To me, the ultimate answer will be solved when some genius is able to create a risk measure for real yields that is the parallel to the spread duration risk which is used for credit risk: If successful, that individual will make a lot of money at a hedge fund...or as a consolation prize will win the Nobel Prize.

Anyway, try this mental exercise: Imagine that the G20 meetings in Korea are a disaster and that all-out currency wars break out which is highlighted with the USD no longer accepted as the world's currency reserve. Both inflation expectations and interest rates scream higher as a result. Nominals would get destroyed but comparable TIPS may not perform too badly since the expected higher inflation would drive their bids higher: This creates the situation which TIPS have proven to do so in the past of having very low duration or even negative duration.

I don't deny that the price of TIPS is sensitive to changes in inflation expectations. Nevertheless, the duration with respect to changes in real interest rates (i.e., the partial derivative) is still higher than the overall duration of nominal bonds. You may be able to construct a scenario, where the price sensitivity to a rise in real rates is temporarily ameliorated (or even ovwerwhelmed) by excessive demand for TIPS due to significantly higher expectations for inflation. The point I was trying to make was that one can't conclude that TIPS are generally less volatile than nominal bonds because they are only sensitive to changes in real rates.