Retirees who decide they want to fund at least some of their retirement income with Treasury Inflation-Protected Securities, or TIPS bonds, have a choice between investing in a ladder of individual bonds or a fund of TIPS bonds. Wade Pfau recently asked at his blog which retirees should prefer.
I first tried to answer the question “Why Bonds?” and then the question “Why TIPS bonds?” before mulling the choice between individual bonds or a fund of bonds. The most important thing to know about these two investments is that an individual bond (or a ladder of individual bonds) is in many ways a very different animal than a bond fund.
The second most important thing to understand is that neither is a better tool than the other in every application. For some purposes, individual bonds will be better and for others a fund will be more suitable.
The topic of bond funds versus ladders has been discussed at length at the Bogleheads website, with the general conclusion that bond funds are no worse than ladders and probably better. When interest rates rise, the fund's value will decline, but the fund will reinvest in bonds that pay higher interest and in the long run, all will be well.
On the other hand, William Bernstein has a well-known dislike for TIPS bond funds because they can't be held to maturity like an individual bond. Their net asset value fluctuates over time so bond funds behave a lot like stock funds. Bernstein believes that our risk-free portfolios should be totally risk-free, so he prefers ladders for retirement income and other known future liabilities.
How do we rationalize two distinctly different views of people who really know what they're talking about? By recognizing that they're talking about two different uses of bonds.
Individual bonds (and ladders of individual bonds) have the unique ability to provide a risk-free, inflation-protected amount of capital at some future date if they are held to maturity. Funds can't do that. That makes bonds an ideal way to fund a future liability, such as a year of retirement income.
Bond funds, on the other hand, do a better job of reinvesting interest without you having to buy an entire $1,000 bond and of rolling into higher return bonds when interest rates rise. That makes funds a great alternative if your goal is to reduce portfolio volatility.
Using a bond ladder to diversify with no targeted future liability, you would purchase a new bond each year with the proceeds of a maturing bond. You would find reinvesting the interest challenging.
Using a ladder to fund retirement, you would spend the interest and spend the principal from matured bonds, so reinvestment isn't an issue. New bonds would be purchased at the long end of the ladder with funds from your stock portfolio.
They're two very different scenarios. I agree with Bernstein when we're talking about generating retirement income (use a ladder) and the Bogleheads when we don't have a specific target date (go with a fund).
Let's look at how each tactic compares in some critical ways.
Holding to Maturity. A bond has a single maturity date when you can be assured that your principal will be returned in full, and TIPS bond principal will be increased at maturity to compensate for the inflation you have experienced. A fund has many bonds with many maturity dates that may or may not be held to maturity by the fund's managers.
Like funds, the value of your bond ladder will rise and fall opposite of interest rates over time, but you have the option of holding bonds to maturity and knowing their values at that future date. The value of a bond fund at any specific date in the future will be unknown. It might be higher or lower than an individual bond would have been.
For example, let's assume I can choose between a $1,000 TIPS bond that pays 2% real interest and matures in ten years on January 15th, 2024 and a TIPS bond fund that holds similar bonds. On January 15th, 2024, the TIPS bond will be worth $1,000 in 2014 dollars. I would be able to sell the fund on that date at its net asset value, which might be more or less than $1,000 in 2014 dollars, depending on interest rates between now and then.
Reinvestment Risk. The interest paid by an individual bond ladder may be difficult to reinvest optimally because it won't typically be enough to buy another $1,000 bond. The interest will probably end up in a low-return cash fund.
Bond funds reinvest easily. Bond funds are a better solution to reinvestment risk if your bonds are intended to mitigate portfolio volatility. Interest from bonds purchased to provide retirement income, however, will be spent, not reinvested.
Minimum Investment. TIPS bonds are issued with $1,000 face value. Investors with small amounts to invest will find a fund easier to deal with.
Capital Gains. Jane Quinn argues that if you buy and hold a bond ladder to maturity, you can't take advantage of capital gains if interest rates decline, while a managed fund could. True as stated, but no one says you must hold individual bonds to maturity and that you can't change your mind.
I purchased TIPS two years ago and was amazed to see the tremendous price increase in such a short time for a risk-less investment. I purchased the bonds to hold, but sold when I realized I had probably benefited from a relatively temporary run-up of prices.
(For the opposite side of the Quinn arguments, see Larry Swedroe's response.)
Maintenance. Of course, it's easier to buy a fund and let someone else do the work if you're OK with the disadvantages of a fund, but I don't find maintenance of a TIPS ladder onerous. A Fidelity representative helped me set up a ladder several years ago and did most of the legwork for free. He called me occasionally with a few choices and we had it set up in about three days. Since then, major brokerages, including Fidelity, have provided online tools that simplify the process. After the ladder is set up, you buy one more rung every year.
Diversification. Owning diverse securities is usually a huge benefit of mutual funds. TIPS, however, have no credit risk, so diversification is not an issue as it would be for municipal and corporate bonds.
Cost. TIPS are a cheap asset to purchase in any form. You can buy individual bonds for free online at Treasury Direct. Several large brokerages sell them with no fee. Of course, you will pay half the bid-ask spread when you purchase them on the secondary market, but that is a one-time cost.
You could pay an advisor to set up a ladder for you. I recently read about a service that charges 35 basis points to do so.
iShares TIP fund (symbol TIP) has a net expense ratio of 0.20%, but that is a recurring annual expense. It's also 10% of the expected real return (2%) of the fund. Compare that to SPY (S&P 500) with a net expense ratio of 0.09% and a possible average return of say, 6%, and it looks expensive. SPY expenses are maybe 1.5% of expected returns, not 10%.
If you're willing to do the work yourself, ladders look cheaper. Even if you pay an advisor 0.35% for the initial purchase, you still come out ahead.
Inflation Protection. Individual TIPS bonds will return additional principal at maturity to compensate for increases in the CPI. Funds make no such promise. Interestingly, Morningstar reports that iShares TIP fund returns are not highly correlated with inflation. Isn't that the point?
TIPS fund prices may outperform inflation and they may not. They should compensate for inflation that exceeds market expectations, however.
Taxes. TIPS have a “phantom income” tax problem whether you buy individual bonds or a fund. You have to report accrued principal annually and interest payments are subject to Federal income tax, but not state tax. Hold them in a Roth account and these problems go away.1
(Interest from TIPS and other Treasuries is taxable as federal income but exempt from state tax when held in a taxable account. Hold them in a traditional tax-advantaged account and you convert them to taxable (state and federal) ordinary income when funds are withdrawn. So, if you have low Federal taxes but very high state taxes, beware.)
Many complaints about bond ladders are legitimate if you're investing in bonds to reduce portfolio volatility, or investing in bonds with credit risk, or not spending the income and matured principal. But, most of them just don't apply to a retirement income ladder.
If you're investing in bonds to improve your portfolio allocation, funds may be just the ticket. I would also recommend a fund if you're unwilling to do the initial setup. After that, it's a little more work once a year.
But, if you're investing for certain annual income, want the lowest cost, prefer to know exactly how much money you will have to spend at a future time and want to be certain you will outpace inflation, I prefer a ladder of individual TIPS bonds held in a retirement account, and preferably a Roth.
How should you set up a TIPS ladder? Please check out my next post, How Many Rungs?
1You can't purchase bonds from Treasury Direct from a retirement account to take advantage of their no-fee feature. Treasury Direct will only work with taxable accounts. You can, however, purchase TIPS bonds on the secondary market from a tax deferred retirement account.