Two things I did not show are when one is better than the other and when the difference is enough to matter.
There are many factors we could use to compare ladders to funds beyond interest rate risk and return. There is the convenience issue, though I hope I have explained that tax reporting is no longer a big issue and that bond desks can do most of the legwork for you. There is the familiarity issue for those who have never purchased individual bonds. TIPS bonds aren't available for every year and some funds can be bought in smaller price increments. There are many ways we could compare bonds and ladders, but not all of them are critical.
One of my objectives for this blog is to simplify retirement finance so it makes sense to most do-it-yourself retirement planners. In that spirit, I will try to unravel this issue by considering three common retirement scenarios for bond funds or bond ladders: funding known liabilities, funding a few years of living expenses, and funding a long retirement of living expenses.
To simplify the explanation, when I use the term "ladder" I will refer to a series of TIPS bonds maturing annually. Ladders can be constructed with many types of bonds, but I will only refer to U.S. Treasury Inflation Protected Securities ladders. I will use the term "fund" or "bond fund" to refer to a fund or ETF that predominantly consists of these TIPS bonds. Furthermore, when I compare a fund to a ladder, I am referring to a fund with an average duration similar to the average duration of the ladder.
Why do I limit the discussion to Treasury bonds when we could ladder most any kind of bond? Two reasons. First, I believe that only Treasury bonds, and especially TIPS, are safe enough for the risk-free portion of a retiree's portfolio. Second, Treasuries presumably have no credit risk, so diversification of individual bonds is unnecessary. The diversification advantage of a fund of corporate bonds, for example, would generally outweigh any advantages of a corporate bond ladder, in my opinion. If you don't buy Treasury bonds, you're probably better off with a fund for its diversification.
Let's look first at the scenario of funding known future liabilities. We might wish to fund four years of a child's college education, for example. We have a good estimate of the cost and the years those expenses will be incurred. Or, we might plan to fund five years of living expenses between retiring at age 65 and claiming Social Security benefits. Finally, we might want to plan funding for 30 years or more of retirement, in which case we plan for 30 or more known future liabilities, our living expenses.
If bonds aren't meant to fund a known future liability, they still have great diversification value in a portfolio. Consider a retiree whose living expenses are completely covered by a pension and Social Security benefits, but who has also saved a large investment portfolio. She will likely need to diversify that portfolio into bonds to manage risk, but holding individual bonds to maturity with no liability to match would provide little additional benefit. That need would be better met by a diversified bond fund, and one not limited to Treasury bonds.
But, for known future liabilities, a ladder of bonds held to maturity has an economic benefit created by the option to hold bonds to maturity that match those liabilities. We can know with relative certainty how much they will be worth in real dollars at maturity. Funds don't provide that option.
To simplify the explanation, when I use the term "ladder" I will refer to a series of TIPS bonds maturing annually. Ladders can be constructed with many types of bonds, but I will only refer to U.S. Treasury Inflation Protected Securities ladders. I will use the term "fund" or "bond fund" to refer to a fund or ETF that predominantly consists of these TIPS bonds. Furthermore, when I compare a fund to a ladder, I am referring to a fund with an average duration similar to the average duration of the ladder.
Why do I limit the discussion to Treasury bonds when we could ladder most any kind of bond? Two reasons. First, I believe that only Treasury bonds, and especially TIPS, are safe enough for the risk-free portion of a retiree's portfolio. Second, Treasuries presumably have no credit risk, so diversification of individual bonds is unnecessary. The diversification advantage of a fund of corporate bonds, for example, would generally outweigh any advantages of a corporate bond ladder, in my opinion. If you don't buy Treasury bonds, you're probably better off with a fund for its diversification.
Let's look first at the scenario of funding known future liabilities. We might wish to fund four years of a child's college education, for example. We have a good estimate of the cost and the years those expenses will be incurred. Or, we might plan to fund five years of living expenses between retiring at age 65 and claiming Social Security benefits. Finally, we might want to plan funding for 30 years or more of retirement, in which case we plan for 30 or more known future liabilities, our living expenses.
If bonds aren't meant to fund a known future liability, they still have great diversification value in a portfolio. Consider a retiree whose living expenses are completely covered by a pension and Social Security benefits, but who has also saved a large investment portfolio. She will likely need to diversify that portfolio into bonds to manage risk, but holding individual bonds to maturity with no liability to match would provide little additional benefit. That need would be better met by a diversified bond fund, and one not limited to Treasury bonds.
But, for known future liabilities, a ladder of bonds held to maturity has an economic benefit created by the option to hold bonds to maturity that match those liabilities. We can know with relative certainty how much they will be worth in real dollars at maturity. Funds don't provide that option.
If you're investing in bonds for diversification and not liability-matching, a ladder has no economic advantage and a fund should be fine.
The second scenario, such as funding the gap between retiring and claiming Social Security benefits or funding college, is a liability-matching problem, but for a limited time. I believe there are signification differences between brief liability-matching scenarios and liability-matching scenarios that could last thirty years or more. Let's consider the former.
Short-duration (about 2.5 for a five-year period, in this scenario) TIPS funds are relatively safe and will not lose much in just a few years, nor do they provide much upside potential. In 2013, a bad year for bonds, iShares intermediate ETF TIP lost 8.65%, and long duration (27) PIMCO ZROZ lost 22% of its value. Short-duration Vanguard TIPS fund VTIP lost just 1.55%.
Short-duration (about 2.5 for a five-year period, in this scenario) TIPS funds are relatively safe and will not lose much in just a few years, nor do they provide much upside potential. In 2013, a bad year for bonds, iShares intermediate ETF TIP lost 8.65%, and long duration (27) PIMCO ZROZ lost 22% of its value. Short-duration Vanguard TIPS fund VTIP lost just 1.55%.
In 2014, an up year for ZROZ that returned over 49%, VTIP lost 1.2%. At the short end, there isn't a lot of risk, nor is there much upside.
While a ladder would seem an obvious choice in this scenario, the fact that the term of the ladder is short means that you won't do a whole lot worse in a fund and there is some potential to do better. If you can tolerate a small shortfall in the worst case, using a bond fund instead of a ladder should work fine for short periods. On the other hand, the ladder is safer and buying a five-year ladder does not entail a lot of inconvenience. The fund has sequence of returns risk. If the possibility of a shortfall is a concern, go with a ladder.
The last scenario I will consider is that of funding 30 years or more of retirement with a TIPS bond ladder. At first glance, it might resemble the 5-year scenario, but funding a much longer period has important differences. I'll cover that in my next post.
To summarize, if you are not trying to match a known future liability, holding bonds to maturity doesn't have a clear economic advantage over a fund. The returns and risks will be different, but we can't predict which will do better. Go with a diverse bond fund.
For matching a few years of a known liability, I much prefer a ladder of TIPS bonds to a TIPS bond fund. But, in this scenario, making the wrong choice is unlikely to make or break your retirement plan. Don't lose sleep over it.