Maximizing portfolio return with very low risk

[Dante]

As a potential RE at 48 with wife and 3rd grader son, here is a way that I am thinking of structuring my portfolio to maximize income and minimize risk. Equity in the house is $0.6M, debt is less than $0.2M. Portfolio size is $1.1M, 85% in taxable, 15% in tax-deferred. The objective is to extract $40K of passive income with some amount of risk.

1. 100K 5 yr CD at 5%
2. 100K 4 yr CD at 4%
3. 350K Moneymarket at 3%
4. 60K I-Bonds @3.67%
5. 125K Dividend paying stocks, 5-6 @ 8%
6. 125K Preferred Shares and REIT @7%
7. 100K Vanguard HY Corporate & ST Bond @4%
8. 100K Vanguard Wellington@4%

Comments?

 

[wabmester]

Where'd you find a MM @ 3%?

If you really wanted a safe 4% yield, why not go with 100% TIPS? Even with the paltry 2% real yield on the 20-year, you'd be yielding close to 5%.

If you're trying to protect principal, your biggest risk is probably in (5), (6), and the HY Corp (which currently pays a lousy risk premium).

 

[Dante]

Have to continuously search for the 3% MM but they are out there. Superior Savings Bank is one.

Are there downsides to owning TIPS 100%?

Thanks.

Dante

 

[wabmester]

Are there  downsides to owning TIPS 100%?

If you hold to maturity, the only risk is deflation, which we haven't seen in a *long* time.

If you sell before maturity, you're subject to the same sort of interest rate risk that any bond would expose you to.

Edited to add: the biggest downside for you may be that the inflation adjustment isn't distributed until maturity.   So, if you need the income on an annual basis, that's probably a deal killer (not to mention that you're taxed on the undistributed adjustment).

 

[Dante]

Wabmester,

At 5% would the 5 yr CDs be better than TIPs? Problem with CDs though is that you have to wait until maturity to get the interest. Would the same apply to TIPS?

Are you 100% in TIPS yourself? If less than 100% what is a good income producing complement to TIPS?

Dante

 

[retire@40]

Problem with CDs though is that you have to wait until maturity to get the interest.

I thought banks allow you to receive the interest without penalty as it is earned. You can receive a monthly check or have it direct deposited to your checking account. It's the principle that you can't touch for 5 years.

 

[wabmester]

I don't think I've ever run into a CD that forced you to reinvest interest -- you should be able to spend the interest as it's generated.   There's very little risk in a 5-year CD @ 5% unless inflation skyrockets within that timeframe.

But there's another factor that you don't seem to be considering.   If you need to live on that 4% your portfolio is throwing off, you realize that your principal is being eroded by inflation, right?    If you're planning to live another 40 years, there's no way your $1M will continue to generate enough income if you consume the full 4% each year.

As for my TIPS exposure, I like TIPS, but I'm nowhere near 100%.   I'm currently 20% real estate, 25% stocks, 20% cash, and 35% bonds (including TIPS).    But I don't need my portfolio to throw off that much income, and I'm perfectly willing to sell appreciated assets to provide part of the income I do need.

So, you might need to revisit your fundamental assumptions about long-term portfolio survival and your need for income (vs cap gains), but that's not how you framed your question.

Edited to add: if you need $40K/yr income, your portfolio needs to crank out something like $70K/yr on average to keep up with inflation.

 

[Dante]

I thought banks allow you to receive the interest without penalty as it is earned. You can receive a monthly check or have it direct deposited to your checking account. It's the principle that you can't touch for 5 years.

Agreed. But some of the community banks and credit unions giving better than market rates were only offering the "full interest at maturity" option.

Dante

 

[MJ]

if you need $40K/yr income, your portfolio needs to crank out something like $70K/yr on average to keep up with inflation.

I am assuming that the $70k/yr would let your descendant's inheret the full $1MM in today's dollars. I don't have any, so I guess I can pare down the $70k to $55 - $60k.

MJ

 

[Cut-Throat]

I am assuming that the $70k/yr would let your descendant's inheret the full $1MM in today's dollars. I don't have any, so I guess I can pare down the $70k to $55 - $60k.

MJ

Yes, I agree with you. People here seem pretty adverse to digging into principal.

I took the 1.1 Million and if you withdraw 40K per year, inflation adjusted for 3% - All you have to do is get a 5% return to have enough money to last for 40 years.

Which means the portfolio only has to throw off 55K Initially to take the 40K per year.

I'm not lining my coffin with Money either. I plan on having 2/3 of my principal gone by time (if) I pass 90 years of age.

 

[markplus4]

I would add a 15% dollop of emerging market stocks (taken from your MM bucket). DRFMX is a reasonable choice, but there are others.

 

[John Galt]

Hey Dante, you are joking right? You forgot to add the smileys

John Galt

 

[Dante]

John,

My mistake. Yes I did forget to add the smileys.

Dante

 

[unclemick]

Buy one of the Vanguard Retirement Series, 2015,2005,Income - auto deduct to checking and go fishing,etc. It's that simple.

Of course if you just gotta putz - I can't help you - heh,heh - got the same problem myself - possibly incurable.

 

[Bob_Smith]

Another thing about TIPS. I bought some on the secondary market with a yield to maturity of a little more than 2.5%. But since they have a coupon of 3.875% they will actually throw off an inflation adjusted ~3.2% of my original investment. So someone who can make it on ~3.2% plus inflation can probably avoid selling off as they go. I see that is one advantage to buying on the secondary market.

Another thing - some believe the govt. is gaming the numbers and understating inflation. That could cut into the return. Furthermore, if that perception spreads, and depending on how much the govt. fudges the numbers going forward, it could impact the market value should you decide to sell before maturity. I own them nonetheless.

 

[wabmester]

Bob_Smith, I don't believe it's true that a higher coupon will help you with cash flow.   Since you had to pay a premium for that coupon, you end up with exactly the same cash flow as if you had bought a bigger bond with a smaller coupon.

Edited to say: I take that back. I think you're right -- you're buying a smaller bond for the same amount as a larger bond with a smaller coupon. So the inflation adjusted principal you get at maturity will be smaller, which means the interest you received must be larger to get the same yield.

Interesting idea....

 

[Cut-Throat]

Wab or Bob,

Could you give me an example of this technique in Dollars and sense? - So I can understand what you're saying. - I'm still a bond idiot.

 

[John Galt]

While we wait for Cut-Throat to get his bond
investing degree ...............
I had a real good experience yesterday with a new broker. Had cash that needed to be put to work
(no lazy money). My old trusted guy (very stodgy
conservative firm) had nothing to suggest that had appeal. I called another local guy and in 15 minutes he got the message. When I went in, he had a big
printout of stuff that pretty much matched what I wanted, all bonds, various yields, pars (premiums and
discounted) call dates etc. Nice to have a bunch of stuff to chose from. And, he didn't try to sell me stocks.
Anyway, ended up with a 20 year bond at par, rated
just above the cutoff for investment grade. Pays 7%
and can't be called for 5 years. I like it!

John Galt

 

[wabmester]

Could you give me an example of this technique

It's not really a "technique," per se.   You can buy bonds as new issues or on the secondary market.   New issues are almost always offered at "par", which basically means you get your original principal back at maturity.    Bonds on the secondary market can be offered at either above par or below par in order to make their coupon match the current market rate.

Example:

Say the current market rate for 10-year bonds is 3.781%.   You can buy a new issue at that rate for par (say, $1000), or you can buy a higher-coupon bond on the secondary market at a premium (say $1100 for a 5% coupon).   Both bonds have the same YTM of 3.781%.

But when the bond you bought at a premium matures, you'll only get $1000 back for your $1100 initial investment.    The difference was distributed as interest.   In this case, interest would be paid out at 4.545% vs 3.781% for the new issue.

Normally, it's a coin toss.   But in the case of TIPS, you don't receive the inflation adjustment until maturity, so buying TIPS with high coupons on the secondary market allows you to have some of that inflation adjusted principal distributed with your interest (just one way of looking at it).

So, if you need the cash flow, Bob_Smith has a solution for you....

 

[Cut-Throat]

Wab,

OK, got it! - Make sense ! - Thanks!

 

[Bob_Smith]

Yep, there are two reasons I bought TIPS on the secondary market instead of direct. The primary reason is because I get an inflation adjusted income stream of ~3.2% of my initial capital, instead of the ~2.5% I would have received buying direct. Of course I get commensurately less at maturity, but I need the higher income stream, and prefer not to be exposed to the market risk and brokerage fees I'd have if I were forced to sell a little each year. The second reason is that I can buy and forget about it for ~28 years. At the time one could only lock in for 10 years through Treasury Direct. If neither of those issues were important for me, I'd use Treasury Direct.

 

[brewer12345]

As a potential RE at 48 with wife and 3rd grader son, here is a way that I am thinking of structuring my portfolio to maximize income and minimize risk. Equity in the house is $0.6M, debt is less than $0.2M. Portfolio size is $1.1M, 85% in taxable, 15% in tax-deferred. The objective is to extract $40K of passive income with some amount of risk.

1. 100K 5 yr CD at 5%
2. 100K 4 yr CD at 4%
3. 350K Moneymarket at 3%
4. 60K I-Bonds @3.67%
5. 125K Dividend paying stocks, 5-6 @ 8%
6. 125K Preferred Shares and REIT   @7%
7. 100K Vanguard HY Corporate & ST Bond @4%
8. 100K Vanguard Wellington@4%

Comments?

I think you are making this far too hard. If you look at the safe withdrawal studies on the REHP, you can reasonably assume 4% on your portfolio if it is invested in a model S&P500/T-bill port. Since you are sitting on $1.1 million, that equates to $44k last time I checked. If you spend under a hundred bucks on some portfolio optimization software and get something with better risk-adjusted returns than the model, you are likely to be even safer than the SW study suggests. I'd gues that adding some small caps, commodities, foreign equity and foreign bond to the mix would greatly boost risk adjusted return.

 

[brewer12345]

While we wait for Cut-Throat to get his bond
investing degree   ...............
I had a real good experience yesterday with a new broker.  Had cash that needed to be put to work
(no lazy money).  My old trusted guy  (very stodgy
conservative firm) had nothing to suggest that had appeal.  I called another local guy and in 15 minutes he got the message.  When I went in, he had a big
printout of stuff that pretty much matched what I wanted, all bonds, various yields, pars (premiums and
discounted) call dates etc.  Nice to have a bunch of stuff to chose from.  And, he didn't try to sell me stocks.
Anyway, ended up with a 20 year bond at par, rated
just above the cutoff for investment grade.  Pays 7%
and can't be called for 5 years.  I like it!

John Galt

JG, given your appetite for credit risky assets with high duration (interest rate risk) as well as your eagerness not to pay taxes, I have to wonder why you haven't jumped into some publicly traded limited partnerships. After all, CHC and MMA pay out roughly 7% in tax free income and increase their distributions over time. Lots of other MLPs pay out handsomely, are usually tax deferred, and also increse their payouts over time. Any reason this isn't attractive?

 

[Dante]

While we wait for Cut-Throat to get his bond
investing degree ...............
I had a real good experience yesterday with a new broker. Had cash that needed to be put to work
(no lazy money). My old trusted guy (very stodgy
conservative firm) had nothing to suggest that had appeal. I called another local guy and in 15 minutes he got the message. When I went in, he had a big
printout of stuff that pretty much matched what I wanted, all bonds, various yields, pars (premiums and
discounted) call dates etc. Nice to have a bunch of stuff to chose from. And, he didn't try to sell me stocks.
Anyway, ended up with a 20 year bond at par, rated
just above the cutoff for investment grade. Pays 7%
and can't be called for 5 years. I like it!

John Galt

John,

Is this a good bond?

Description:GMAC
Coupon: 7.000%
Maturity: 11/15/2024
Rating: Baa1/BBB- Moody's/Standard& Poor's
Price: 100
Yield: 7.000% To Maturity
Callable 11/15/2009

I am thinking of getting it?

Dante

 

[ESRBob]

Dante,
Yield to Maturity is essentially meaningless on a callable bond: you need to calculate the yield to call as that bond will probably be called in 3 years in 2007. So you are buying a 3-year bond, not a 20 year bond.

Re: your original post -- I think you need a lot more equity in your portfolio to counter inflation and give yourself return. Your fixed income is designed to dampen volatility, not pay real yields that will make your hoped-for 4% SWR come true. To see this, just look at the yields: anything less than 7% (4% SWR +3% assumed inflation) is pretty much guaranteed to under-perform your 4% SWR -- that is fine if it represents up to 40% or so of your portfolio, is laddered and/in shorter duration bonds that you hope to retire and buy something longer when/if bond yields return. But you can't have an average 3-4% nominal yield on an 85% fixed income portfolio and still expect to have your 4% SWR! Nice work if you can get it, but you can't. Same goes for TIPS paying 2% real -- you are planning to take out 4% real (meaning you want to keep the value of your portfolio intact and growing by at least the inflation rate over decades of ER), so how can this work if you have major chunks of the portfolio locked in at 2% real?

Again, if the portfolio is properly diversified, you can do this with a portion (40% or less of total portfolio) in FI, underperforming your SWR and waiting for higher yields, while dampening volatility and giving you safety of principal. But it is a part of a bigger plan, not the whole plan.

If you haven't already, pick up Bernstein's 4 Pillars and study it till you are comfortable. Post any questions from the book you'd like the group to answer.

ESRBob