Bonds are a powerful tool for retirement planning. They are able to provide specific cashflows at known points in time in the future with relatively low levels of uncertainty (depending on the bond issuer). This also means that they are able to be used in a number of different ways, to accomplish a number of different retirement planning objectives.
Three of the most common ways that bonds can be used as part of your retirement income plan are:
- As part of your investment portfolio to target a specified level of risk that you are comfortable with.
- To create a pool of reserve or buffer assets.
- Holding individual bonds to maturity to generate the desired cash flows to fund expenses either on an individual or ongoing basis throughout retirement.
(As an aside, another use for bonds is to match the duration of your overall retirement liability to mitigate your overall interest rate risk. This is an advanced technique that involves a decent amount of math, so we won’t discuss it here.)
Each of these approaches can be useful within your retirement plan (and there will be some retirees who will use all three!) so let’s consider each in turn.
Bonds as Part of Your Investment Portfolio
Most investors are familiar with the use of bonds as part of their investment portfolio – usually in the form of a bond mutual fund or ETF. Within your investment portfolio, the typical goal is to mitigate the risk from your riskier investments (e.g. stocks), and get your overall portfolio risk down to a level that you are comfortable with. In fact, setting the ratio of stocks to bonds is the most important decision you’ll make about your investment portfolio.
With this approach you can think of bonds as the ballast of your investment portfolio. Bonds have a lower expected return than stocks, but they help provide stability to your portfolio when the markets get rough. They are there to essentially keep you pointed in the right direction.
Because of their role in your investment portfolio, you will generally not want to include riskier bonds – bonds that take higher levels of Term and Credit risk – as you are looking for overall risk reduction from your bonds, rather than higher levels of return. When looked at in terms of expected return per unit of risk, it makes more sense to take your risk with your stocks than it does with your bonds. This means that you likely will want to tilt your portfolio towards shorter term and higher quality bonds (especially if the yield curve is inverted).
Bonds in Reserve
One other common use of bonds is as reserve or buffer assets and probably more commonly known as your emergency fund. These are types of assets are relatively straightforward. It is money held outside of your investment portfolio (at least from a mental accounting standpoint), that is there to provide some degree of protection for when you are faced with negative events.
This could be anything from unexpectedly needing to repair your roof, to dealing with a bad year in the market. The important thing is that these assets are not earmarked for “normal” spending. They are specifically there to provide an additional level of protection.
Bonds can be very effective buffer assets because they are relatively safe and liquid, but are generally going to be able to keep up with inflation (or even more – though you would probably want to be even more conservative with the types of bonds you select here than in your investment portfolio). However, there are two important notes here:
- You want your buffer assets to be minimally correlated with your other assets – primarily your investment portfolio. If you have a very conservative investment portfolio you may want to look at other options for your buffer assets.
- You will likely want to use bond funds or ETFs as reserve assets. This is both for convenience, as well as liquidity. Often when you need to access your buffer assets you need to do some quickly. Trying to sell individual bonds quickly (aside from US Treasury Bonds) can often mean accepting a lower price on the sale.
Holding Individual Bonds to Maturity
The third route involves holding individual bonds to maturity to provide the desired income to fund either specific expenses or annual expenses on an ongoing basis throughout retirement. In this method, you would purchase individual bonds with an eye towards matching the payments from maturing bonds and coupon payments to either meet an individual spending goal at some point in the future, or provide a steady and known stream of contractually guaranteed income to meet planned expenditures.
If you are looking to meet a specific spending goal at some point in the future, you will ideally be looking to use zero coupon bonds, because you can align the singular maturity payment with the expected expense. This will reduce your exposure to interest rate risk from the coupons that a “traditional” bond would pay out over time.
If you are looking to meet your ongoing expenses with individual bonds, this is typically referred to as a bond ladder. There are two flavors of bond ladders:
- Fixed Length Ladders
- Rolling Ladders
Fixed Length Bond Ladders
Fixed Length Ladders are designed to provide income over a specific period of time. The most common use of these types of ladders is to provide a bridge to social security.
Since many people choose to delay when they take their Social Security benefits, they often face a gap in their reliable income at the start of retirement. A (relatively) short term bond ladder can often help to bridge this gap.
Rolling Bond Ladders
Rolling Ladders are designed to operate indefinitely. As one bond matures you will purchase another bond at the end of the ladder to keep it going. Typically this is used as part of a Time Segmentation strategy designed to provide a higher level of reliable income, while still maintaining the optionality to make changes to your plan as your situation may change.
Time segmentation strategies are based around breaking your portfolio into different “buckets” based on when that money will be used to meet your retirement expenses. Typically, this will involve a rolling bond ladder, and a riskier bucket that will be used to refill the bond ladder through time.
If you would like to learn more about the Time Segmentation approach (how you choose to refill the bond ladder can get relatively complex), you may wish to look at our Understanding and Using Time Segmentation Strategies[sales page] workshop in our membership site, the Retirement Researcher Academy.
Bonds are incredibly versatile tools. The goal is to use them in the way that fits best with your overall retirement income plan.
To find out more about how to build an investment portfolio that works for you, read our eBook 9 Principles of Intelligent Investors.
