Asset Dedication- Thought on bond allocation close to retirement

[NorCal]

As a relatively new member of the forum, I thought I would share a book that has some very valuable thoughts on managing cash flow and reducing portfolio risk for those near retirement and those already retired.  This book was co-authored by one of my professors in Business School, and he is someone I have a lot of respect for.

To oversimplify it a bit, the idea is that you can reduce risk in your bond portfolio by buying bonds directly instead of buying a bond fund.  Lets say you know you're going to retire in 5 years, and you know that you will need $30K in your first year of retirement.  Why don't you just go buy $30K worth of 5 year bonds directly from the government (or a safe corporation if you're willing to take some risk)?  Unlike investing in a bond fund, you are guaranteed to get your principle back in 5 years.

You can then wait another year and re-allocate another $30K to five year bonds for your second year of retirement.


http://www.amazon.com/ASSET-DEDICATION-Wealthy-Generation-Allocation-ebook/dp/B001E5W2I8/ref=sr_1_1?s=books&ie=UTF8&qid=1406604954&sr=1-1&keywords=asset+dedication

[milesdividendmd]

I love the strategy. it's main value, as I see it, is not paying an expense ratio on your bonds.

The risk you're taking of course is interest rate risk (The loss of market value in your bond as interest rates rise. and inflation risk, (The loss of the spending power of your money by the time you get your principle back.)

Both of these are well dealt with by building a TIPS ladder.

The best I've ever seen tips ladders explained is in this post by grok from bogleheads:

http://www.bogleheads.org/forum/viewtopic.php?t=71927
 
Enjoy!

[TomTX]

Where is a good place to look at cost/yield/etc on various TIPS?

[brooklynguy]

I think the strategy's main value is actually the "certainty" of getting back your principal plus interest in five years (unlike an investment in a bond fund).  I put "certainty" in quotes because the "certainty" actually ranges from "near absolute certainty" in the case of the US government to varying lower levels of certainty for less creditworthy issuers.

[milesdividendmd]

Where is a good place to look at cost/yield/etc on various TIPS?

http://online.wsj.com/mdc/public/page/2_3020-tips.html

[milesdividendmd]

I think the strategy's main value is actually the "certainty" of getting back your principal plus interest in five years (unlike an investment in a bond fund).  I put "certainty" in quotes because the "certainty" actually ranges from "near absolute certainty" in the case of the US government to varying lower levels of certainty for less creditworthy issuers.

Is this comment for the benefit of non-American mustachians?

[brooklynguy]

I think the strategy's main value is actually the "certainty" of getting back your principal plus interest in five years (unlike an investment in a bond fund).  I put "certainty" in quotes because the "certainty" actually ranges from "near absolute certainty" in the case of the US government to varying lower levels of certainty for less creditworthy issuers.

Is this comment for the benefit of non-American mustachians?

Not sure I understand what you mean.  My point was that when you invest in a bond fund, your investment is subject to some level of volatility (e.g., if interest rates go up after you invest, you may end up selling your shares at a loss).  When you invest in an individual bond and hold it until maturity, you are guaranteed to get back your principal plus interest (unless the issuer defaults, which is virtually sure not to happen in the case of the US government, but has a higher likelihood of happening if the issuer is XYZ Corp.)

[milesdividendmd]

Right,  but the point I was making is that I'm not aware of any non-governmental TIPS.  After all the "T" is for treasury.

The inflation protection is what ensures you get your principle back with TIPS, not that they are individual bonds.  After all if you get your principle back in 30 years on a standard treasury note and your dollars have lost 2/3 of their purchasing power, have you really gotten your principle back?

[brooklynguy]

Yes, I agree with all of that.  I was responding to your comment that the main value of buying individual bonds instead of buying a bond fund is avoiding the expense ratio.  That's not the main value; the main value is avoiding the risk of loss of market value (due primarily to changes in the general interest rate environment, but also other factors like a geopolitical condition that raises questions about the issuer's ability/willingness to pay out on the bond).

Inflation risk exists whether you are buying individual bonds or a bond fund.  I agree that TIPS are a handy tool for dealing with inflation.

To answer your last question (which maybe was intended to be rhetorical?), I would argue that yes, you have gotten your principal back, but your principal is worth less now than it was when you invested it.  But that's really a difference in semantics only.

[milesdividendmd]

Yes, I agree with all of that.  I was responding to your comment that the main value of buying individual bonds instead of buying a bond fund is avoiding the expense ratio.  That's not the main value; the main value is avoiding the risk of loss of market value (due primarily to changes in the general interest rate environment, but also other factors like a geopolitical condition that raises questions about the issuer's ability/willingness to pay out on the bond).

Inflation risk exists whether you are buying individual bonds or a bond fund.  I agree that TIPS are a handy tool for dealing with inflation.

To answer your last question (which maybe was intended to be rhetorical?), I would argue that yes, you have gotten your principal back, but your principal is worth less now than it was when you invested it.  But that's really a difference in semantics only.

Buying individual bonds does not protect you from loss of market value. That's a misconception.

In a rising interest rate environment an individual bond loses value in proportion to its maturity every bit as much as a bond fund loses value in proportion to its average maturity.

This is why bonds sold on the secondary market in a higher interest rate environment are sold at a discount.

Actually with individual bonds this loss of value is even worse as there is less liquidity and a higher bid/ask spread.

[brooklynguy]

I specifically said when you buy an individual bond "and hold it until maturity," which is the strategy the OP referred to and which DOES protect you from loss of market value.

[CanuckExpat]

I think Bernstein is recommending something similar now a days too:
"So, I see TIPS as a defeasing asset class. In other words, you use it to pay for your living expenses, or offset living expenses at some future date. So I'm not a big believer in buying a TIPS fund. I believe if you're going to buy them, you use them just for that purpose, and you use a ladder. Buy them at 5, 10, 15, 20, 25, 30 years as long as you think your retirement is going to last, and those are sitting there to pay for those living expenses at those points in the future."
http://www.morningstar.com/cover/videocenter.aspx?id=397758
http://www.bogleheads.org/forum/viewtopic.php?f=1&t=136125

There's nothing wrong with this strategy (assuming the US government doesn't default), but you possibly need a lot of capital...

[NorCal]

Actually, you are 100% protected from a loss of market value, assuming you are buying bonds at or below par value.  The day you buy the bond, you know the par value, so you are purchasing a guaranteed cash flow in X years.  The change in market value of the bond does not change this.

You are correct that the current price of a bond may potentially be above par value.  But I imagine these bonds would be largely relegated to high-yield issues and were issued a long time ago.  It's pretty easy to not buy those bonds.

The simplest way to execute this strategy is to buy newly issued govt bonds directly from the US Treasury, which guarantees you won't be buying at either a premium or a discount.

I'm personally not a fan of TIPS for tax reasons, but to each their own.

[BooksAreNerdy]

I am still learning about bonds, I read that the gains on bonds in taxable accounts is much higher than stocks. Is this the case for govt issued bonds?

Can anyone explain the tax implications of bonds? In a 401k, trad IRA? Roth IRA? Taxable acct? Just plain slips of paper bonds? Is there a better or worse place to hold them? If they are taxed higher, would it be best to buy them in a trad IRA and do a Roth pipeline once we are retired to avoid being taxed on them?

I don't know what I don't know about bonds and taxes, so any tidbits f knowledge are appreciated!

[CanuckExpat]

Can anyone explain the tax implications of bonds? In a 401k, trad IRA? Roth IRA? Taxable acct? Just plain slips of paper bonds? Is there a better or worse place to hold them?

See here for details: http://www.bogleheads.org/wiki/Principles_of_tax-efficient_fund_placement

Essentially bonds are not tax efficient compared to equities, they are treated as ordinary income. You want to hold your bonds in tax sheltered/deferred accounts as much as possible: i.e buy your bond funds in 401k, IRA, etc, and your equities in your taxable account.

_{Edited to fix typo}

[BooksAreNerdy]

Thanks so much!