After my last few columns on TIPS bonds, beginning with Why Bonds?, several people have asked what I would recommend they do to implement a bond portfolio for retirement income today. One reader asked if I could recommend funds.
(That reader posted a comment while I was on vacation and I somehow lost the post. I apologize. I try to respond to every reasonable comment.)
I don’t generally recommend specific products. I am a firm believer in index funds, so I look for mutual funds and exchange-traded funds with low cost. However, I have read that iShares Barclays TIPS Bond Fund (symbol TIP) and Vanguard Inflation-Protected Securities fund (symbol VIPSX), together hold half of all TIPS dollars invested through fund companies. I have owned both at one time or another. Charles Schwab also offers Schwab Treasury Inflation Protected Securities Index Fund (symbol SWRSX).
I would head to Treasury Direct for TIPS bonds to be held in a taxable account with no purchase fee, though that is often the worst place to hold them because of their tax problems. To hold TIPS in a retirement account, you need to buy them on the secondary market though a brokerage that offers retirement accounts. Treasury Direct does not.
You can find a list of all outstanding Treasury bonds, strips (zero-coupon bonds) and Treasury inflation-protected securities (TIPS) at The Wall Street Journal’s Market Data Center. That doesn't mean all of those bonds are available to purchase, however. Check with your brokerage's bond desk for available issues. (The Fidelity and Vanguard bond desks have been extremely helpful in answering questions and helping find the kind of bonds I want.)
So, what would I do about securing future income with bonds today?
I'd wait.
Interest rates are at historical lows today. They have been held down artificially by Federal Reserve Board actions responding to the 2007 global financial crisis. While I don’t believe anyone can predict future interest rates, it would seem that there’s is a lot more room for rates to go up than further down at this point. The Fed has announced it’s intentions to let rates rise in the near future.
Buying bonds today would lock in historically low interest rates. Wade Pfau recently provided an analysis showing that rates are currently so low that a retiree can only buy about 27 years of income today with a 4% annual withdrawal rate.
Purchasing future guaranteed income is historically expensive today and if I were you, I would wait until it is cheaper. (I wonder if the Fed realizes how badly their actions have impacted older Americans.)
Purchasing future guaranteed income is historically expensive today and if I were you, I would wait until it is cheaper. (I wonder if the Fed realizes how badly their actions have impacted older Americans.)
Furthermore, as rates rise, bond values will sink. Although I prefer TIPS ladders to funds, funds would likely be the better bet if you insist on purchasing them today because they will take better advantage of rising interest rates than a ladder will.
I recommend you stay in short term, high quality bond funds (which, themselves, provide inflation protection) and cash until rates move up closer to the historical 2% real return for TIPS.
Fidelity offers Treasury bonds directly from auctions with no commission. It is not necessary to buy through Treasury Direct. I believe Vanguard does as well.
ReplyDeleteI mentioned this in "Why TIPS Bonds" in my January 9 post at http://theretirementcafe.blogspot.com/2014/01/why-tips-bonds.html, but it bears repeating.
ReplyDeleteSeveral large brokerages sell Treasuries with no fees including Vanguard and Fidelity. There are no fees at Charles Schwab if you purchase them online.
Not only is it not necessary to purchase through Treasury Direct, it is advantageous not to if you want to hold them in a retirement account, as I also explained in an earlier post. In that event, you need to buy them through a brokerage that offers retirement accounts.
I've been thinking about the virtues of laddering with bond funds, as opposed to individual bonds, leveraging the diversifying and low-cost benefits of funds while protecting some kind of predictable YTM otherwise subject to rate risk in constant maturity funds owned outside of a 'ladder' process.
ReplyDeleteRolling forward the proceeds of a conventional individual bond ladder each year without spending it is essentially the same as owning a bond fund of that average maturity. There should likewise be a process for rolling down a year's worth of future expenses through a ladder of bond funds with decreasing average maturities and spending the last short-term cash-equivalent rung each year that will provide a YTM similar to consuming a fixed ladder of individual bonds.
Presumably you could do this buying from equities each year at the top of the fund ladder the PV of a future year's projected expenses discounted by the fund's current YTM that lines up with the average maturity of that longest bond fund (say 7-9 years, or more if you want to extend), then sell from the long fund each year the current value of the previous year's purchase and buy the intermediate fund (5-7 years), then sell from the intermediate fund the current value of the 2nd previous year and buy the short term fund, then from short to mm, and from mm into your pocket each year.
It gets complicated by having enough funds of varying maturities to create a ladder, or by buying each year but perhaps rebalancing fund to fund only every other year or more if the average maturities between rungs are spread by 2-3 or more years.
The key is buying the PV each year at the long end and moving money down the ladder to gradually shorter maturities until it 'matures.'
Using funds means you can add some credit risk to the mix where that would not be advisable in a small individual bond ladder. Aside from the math and tracking involved in rebalancing, it's easy to execute without having to talk to Sherman McCoy at your friendly neighborhood bond desk, and paying his commissions. The spreads on funds are typically lower than on individual bonds, so you keep more of the yield.
Thoughts?
You could certainly do that, but bond funds and bond ladders are two different animals. You cannot hold a bond fund to maturity, so you would have interest rate risk, which is the point of having a ladder. If you invest in Treasuries, there is no credit risk in either scenario. Also, commissions on Treasuries are low, even commission-free at large brokerages. If you don't want to speak to the bond desk, even commission-free, you can buy them online.
DeleteYou're talking about different kinds of risk, which I will address in my next post.
Thanks for reading!
Dirk: how about a ladder target-maturity date ETFs? http://finance.yahoo.com/news/target-maturity-bond-etfs-hedge-112034816.html
DeleteLower credit risk because holds lots of bonds; no loss of principal risk because you can hold till maturity. (Yes, risker than holding laddered TIPS, by definition). What do you think?
This comment has been removed by the author.
DeleteI personally don't care for them. There aren't enough maturity dates available. And lower credit risk than what? Treasuries have no credit risk so you don't need to diversify. These ETF's are also exposed to default risk, so you don't get the same guaranteed return of principal as a TIPS bond. More importantly, the ETF's I've seen are corporates which are, of course, riskier than Treasuries and they don't guarantee a real return.
DeleteThe point of a TIPS ladder is to provide certain, real income at a specific future date. You could ladder these ETF's, but I don't think it would look much like a TIPS bond ladder.
Mr Cotton writes: "Purchasing future guaranteed income is historically expensive today and if I were you, I would wait until it is cheaper. (I wonder if the Fed realizes how badly their actions have impacted older Americans.)"
ReplyDeleteA proportion of pre-retirees, who were highly invested in assets which have appreciated during the central-bank's bond-buying spree, such as equity, will have done better than expected, of course, because they now have much more valuable assets to exchange for guaranteed income. Those who were cautious and stuck to safer investments have suffered.
True. Equity holders have done exceptionally well. Those who have been hurt are retirees trying to lock in future income and those who invest in fixed income products from CD's to bonds. Some households without equity positions made that investment decision to avoid risk and this situation is the result of that decision. Many others simply don't have enough wealth to risk in the stock market.
DeleteThis comment has been removed by the author.
ReplyDeleteHope it's not too late to add some discussion here; I was just introduced to your blog in a Wade Pfau email this morning and am glad I was. Your writing is very clear and appreciated.
ReplyDeleteI am particularly interested in bonds these days as I have recently sold a substantial (but not all) portion of our equities on the assumption that at least some day interest rates will rise and/or some of the exuberance in the equities market will cool. I was quite fortunate in the past few years to ride it up and hate the thought of experiencing a fall. And thus, bonds, despite their low rates of return are looking attractive.
On the assumption that interest rates will increase over time I feel that a bond ladder (such as TIPS) is best. Although the rates are low, hold them to maturity to avoid locking in the reduction in bond value as interest rates increase. And, gradually, as rates go up, heck, my ladder will throw off more income.
Which leads to a question: there was some mention of some sort of bond funds, including those that hold TIPS. As you wrote, they never "mature" per se. But, unless they promise to never sell before maturity, won't the value of the fund (as measured in price/share) decline as interest rates increase? Although I might then dollar cost average into it, thereby buying more for less, this might feel like chasing returns or hopeful investing.
Thanks!
It's never too late, Barry!
ReplyDeleteFirst, what you are describing with stocks is market timing, and I would be remiss if I didn't mention a Morningstar study that shows most mutual fund investors underperform their mutual fund's returns by about 3% and most market timers do far worse, losing money on their investment on average of 3%. That's an absolute 3% loss, not a 3% underperformance.
If you buy a ladder today and hold to maturity you will, in fact, avoid capital losses on the bonds but you will also lock in today's historically low interest rates.
There are TIPs bond funds like Vanguard Inflation-Protected Securities Investment Fund and TIPs ETF's, like iShares TIPS Bond ETF. They will lose value, just like a bond, if interest rates rise. The longer the average duration of the fund or ETF (you can find this at Morningstar.com), the farther their value will decline for every percent rates rise.
When rates rise, a fund (or ETF) will decline in value due to the capital loss, but will restock with higher coupon bonds and eventually pay back the loss. (This is how duration is calculated.)
A study published by Vanguard some time back showed that if you're investing in bonds for a specific expense (or maturity) date, then a bond ladder might be preferable. If you're investing in bonds for portfolio "ballast" with no end date in mind, a fund will probably make up for capital losses in higher coupon newer bonds.
Sounds like you're trying to time the bond market, as well. I'd proceed with caution.