Death by bonds

I’m not a huge fan of investing in bonds, although I do invest in them from time to time. In general, their prospective returns are lower than stocks, they’re taxed at marginal income rates, and individual bond issues are harder to research/buy/trade than individual stocks. However, the most surprising reasons that I’m not a bond fan are;

• they don’t make a bit of difference to safe withdrawal rates in retirement
• they are often used in a completely detrimental way in retirement portfolios

If you look at the research on safe withdrawal rates (my posts on it here) in retirement, using the portfolio value retirement model, you find that replacing the bond component of retirement portfolios with money market funds makes no difference to the amount a retiree can safely withdraw from their portfolio annually. Quoting William Bengen in Conserving Client Portfolios During Retirement;

In fact, consideration of all the data leads to the conclusion that money market funds can replace completely all other types of fixed income investments we have so far considered without any adverse effects on withdrawal rates….This is such a surprising conclusion, and so contrary to current investment adviser practice, that I don’t expect it to be embraced.

Wow! Read that again. The famous 60/40 stock bond allocation can (should) really be 60/40 stock cash. Why take on the extra volatility and credit risk of bonds when an investor can do just as well in cash? And probably sleep better at night to boot. The reasons behind this surprising conclusion have to do with the lower volatility of cash vs bonds and most likely their lower correlation with stocks.

And it gets worse. Many retiree’s bond allocations are invested in bonds without re-investing the interest income. Remember that the portfolio value retirement model, on which SWRs are derived, assumes re-investment of all income. So, from the get go, many adviser are not properly implementing the retirement model at all. The thinking here is that bonds are safer than stocks, due to lower volatility, and the retiree needs income to live, thus the bond income is used to fund living expenses. What effect does this have on a retiree’s standard of living? The table below provides an example.

In the model above I started from a retirement spending need of $4,000 per year and a $100K bond portfolio. Assuming a 25% marginal tax rate I then calculated the bond coupon needed to generate a break-even income in the first year of $4,000. That rate is 5.34%. I then modeled the effect of an inflation rate of 3% on the retiree’s portfolio. Because inflation increases every year and the bond coupon, i.e the retiree’s income, does not increase, the retiree falls behind every year and then must tap the bond principal just to maintain their standard of living. They key here is that inflation always compounds over time. If a retiree does not have investments that also compound over time then they will fail to keep up with inflation and be forced to tap into their principal. Now, these depletions can last a very long time and may very well last long enough to keep the retiree solvent but it doesn’t seem like a happy retirement to me.

I happen to have personal experience with this. Years ago, before I knew what I was doing with investments, I watched as my grandmother’s retirement portfolio got eaten away by inflation, in particular medical inflation, as her financial adviser kept most of her assets in ‘safe’ bonds paying fixed coupons. Every year she had to adjust her real standard of living lower, eventually not being able to afford living on her own any more because she didn’t have the money. It doesn’t and shouldn’t have to be this way.

Lastly, how does this impact the uses of bonds in the dividend retirement model? Well, as in the portfolio retirement model, they may not be necessary at all. Keeping the non stock assets in cash may be the best thing to do. This provides dry powder to use in market corrections that can be used to buy more great dividend paying stocks at great yields. This also helps to reduce portfolio value volatility, which while not important to dividend income, can surely effect an investor’s ability to sleep at night. Personally, I usually keep 20-40% of my portfolio in cash. Only in very few instances have I been fully invested. And yes, some of that cash sometimes goes into bonds, like my recent muni bond investment, but that is usually more of a shorter term trade than a long term investment.

Another potential option, especially in a world of low short term rates, is to use bonds to provide an income buffer. For example, an investor can have a portfolio of dividend paying stocks that generates enough income to cover retirement expenses adjusted for inflation. The investor can then have a bond portfolio that generates 20% more than his retirement needs to provide a buffer in the event of a dividend cut. Since the income from the bond portfolio would only be needed in the case of a dividend cut the investor can reinvest the bond coupons and thus compound the value of the bond portfolio, thus eliminating a key detriment to owning bonds. This way the investor can tailor the portfolio to their particular risk tolerance (measured by the volatility of the portfolio value) while meeting the ultimate goal of generating enough income to keep up with inflation.

Now, how counter intuitive is that? Don’t reinvest your dividends but make sure you reinvest your bond income!