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.
A few questions for the scenario of funding five years of living expenses between retiring at age 65 and collecting social security at age 70: At what age should one buy the TIPS bonds or TIPS bond fund? I assume before age 65? I And if buying the fund, does one just invest the full amount needed for the time frame in mind, e.g. if you need $10,000 per year, put $50,000 in a TIPS bond fund? Finally, with interest rates as they are, do you recommend buying TIPS bonds or TIPS bond funds now if, let's say, one is 4-5 years from retirement? Thanks.
ReplyDeleteThere is arguably no better time than "now" to buy a bond or fund, no matter when "now" is, since interest rates are unpredictable. Waiting would mostly be market timing.
DeleteThe amount to invest is the amount you will need in the future discounted by the yield of the bond with that maturity for the number of years until you need it. For instance, if you need $10,000 in 5 years and 5-year maturities are currently yielding 2%, you need to invest the present value of $10,000 discounted at 2% for 5 years, which works out to $9,062. Of course, that's easy to figure with individual bonds. Buy $10,000 face value of bonds that mature in the year you need the money. If yields for that bond were 2%, it would cost you about $9,062. (The bond market has figured out the investment requirement for you.) In any case, your total amount will be less than $50,000 by the interest earned for five years.
Do this separately for each of the five years because the number of years until you need the money and the yields will change with each year. You can use a present value calculator like this one. The future value is the amount you will need; the present value is the amount you need to invest.
If you chose a bond fund of similar average duration (about 2.5 years), discount the future required income ($10,000) by the expected return of the fund and for the number of years until you need the money. This will be an approximation, but that's the best you can do with a fund.
If you can handle a shortfall should rates rise in the next few years, you wouldn't have a lot of risk with funds this short and with rates at historical lows, you might do better than the ladder. You won't do a lot better or a lot worse in any case. If you want to be certain that you won't have a shortfall, buy a ladder.
Lastly, Wade Pfau wrote a detailed piece on how to out together a long ladder here. Putting together a 5-year ladder would be far easier.
Excellent question. Thanks!
One important point that should be made when creating a TIPS bond ladder is that it is possible to actually lose principle when purchasing TIPS. This is especially true in the secondary market. If a TIPS bond is purchased with the inflation adjusted price above par and the inflation factor at maturity is lower than at the time the bond was purchased all that will be returned at maturity is the par value of the bond (plus accrued interest). Until the current deflationary events due to the decrease in energy prices, such an event was pretty much an academic exercise. However with the recent bond rally, there are some short-term TIPS on the market that have the possibility of making this event a reality. It all depends on how long deflation continues. As of today, you have to go out to a maturity of 1/15/25 before you can find a TIPS that has a positive yield to maturity. As a result of this, TIPS don't even offer a zero-sum game for maturities less than 10 years. At the moment, the only inflation adjusted vehicle out there not affected by deflation are iBonds. The downside to iBonds is that they have to be held for five years in order to avoid incurring an early redemption penalty. That doesn't help much with building a bond ladder in the 1 to 5 year range. Until bond yields recover, it's really not a good time to be building a bond ladder. A month ago, you could purchase TIPS with a positive YTM with maturities under 5 years. There were even a few available for a short amount of time with inflation adjusted prices below par. That was the time to load-up on short-term TIPS. Until TIPS offer inflation adjusted prices below par and a positive yield to maturity they are just way too expensive. TIPS are supposed to provide insurance against unexpected inflation. In the face of certain deflation they are not a very attractive proposition.
ReplyDeleteThanks for writing. I always hope to spark a discussion with my posts. I believe I responded to the issues you raise in the comment below.
DeleteOops! I missed one. I didn't mention iBonds in the post, but I like them. There is a penalty if you redeem them in less than five years, as you mention, but that is only a problem if you are building a ladder to mature in less than 5 years. A 60-year old building a ladder to fund expenses from age 65 to 70, for example, wouldn't be affected.
DeleteYou may also have a problem with the purchase limit. I believe it recently increased to $10,000 a year. By jumping through some hoops and buying some paper and some electronic in both your name and then a spouse's, I believe you could legally purchase up to $20,000 per household. Check with TreasuryDirect.com. But that could be augmented with TIPS bonds if it isn't enough.
How can you recommend building a TIPS bond ladder when everything with a maturity date less than 01/15/25 has a negative yield to maturity? Another
ReplyDeleteproblem with TIPS at the current moment is that anything purchased on the secondary market with an inflation adjusted price over par runs the risk of losing
principle due to deflation. That used to be only a theoretical possibility. For the shorter term bonds that situation could become an actuality if deflation sticks
around longer than everybody's expecting. If you can't buy a TIPS bond for at least par it's just too expensive a proposition. Buying at par is bad enough these
days. It guarantees that you'll be playing a zero-sum game regardless of inflation/deflation during the term of the bond. Under that scenario, at least you'll
maintain the principle of the bond. In deflationary times, purchasing TIPS above par merely guarantees the retention of purchasing power. The difference
between the two isn't semantics, it's real money. A month ago, there were a few TIPS bonds that could be had for under par with maturities under 10 years. That
particular event hadn't happened for years. For the investor who wishes to buy and hold TIPS to maturity as part of a bond ladder you just have to be patient
and wait for the proper opportunities in the bond market. It's taken me almost 2 years to build a TIPS bond ladder with maturities between 5 and 10 years.
Prior to that when every TIPS out to eternity had a negative YTM, I had to use iBonds and CD's to fill-in the 1 to 4 year maturity range. These purchases weren't made to create a true income stream. They were made to help me understand the mechanics of purchasing inflation adjusted Treasuries. This is probably the absolute worst period of time to engage in purchasing TIPS as part of a buy and hold strategy. There has been a lot more money to be made trading TIPS during the course of the last couple of years. Since trading wasn't the purpose of the exercise, the irony of the situation was beyond annoying. It's awfully hard to hold a bond with a market value that provides a gain worth several multiples of what can be expected from the annualized yield of the bond. This just proves that it is an excellent time to be selling TIPS. So, it's a crazy time to be attempting to build a bond ladder. In the face of negative YTM's and deflationary pressures I wouldn't call postponing purchasing TIPS market timing. It's more a survival tactic.
In response to your opening question, let me point out that this is a post comparing ladders to funds and nowhere in the post do I suggest when you should purchase either.
ReplyDeleteNo one knows when to buy bonds because no one can predict future interest rates. According to the efficient market hypothesis, all of this information is built into the current prices of TIPS bonds and they are neither under-priced nor over-priced.
Any attempt to gain an economic advantage by waiting for a different price is market timing. If you believe that you can predict future asset prices, then you're not going to be a fan of my blog.
Further, these are not "deflationary times." Inflation ran a little under 1% last year. Deflation is rare in the U.S. and extended periods of deflation far more rare. The last time we saw two years of deflation in a row were 1938-39, when we were on the gold standard.
There might be deflation in the future (again, unpredictable) and it would be prudent to have a hedge. You can do that by investing some of your bond money in nominal bonds.
Lastly, there are worse things than a tiny loss of capital – like a big loss of capital. The purpose of a TIPS bond ladder is to preserve capital, not to maximize return. Safe investments never maximize return. Take risk in the risky part of your portfolio.
Thanks for your comments.