The Essentials Of Bond Laddering For Retirement

Wade Pfau, Ph.D., CFA

by Wade Pfau, Ph.D., CFA

March 6, 2017

Those seeking a do-it-yourself approach to duration matching with bond funds may underestimate the difficulty of the task.

Duration-matching is not straightforward when shares of the bond fund must be sold to meet ongoing retirement expenses. If rates have risen, shares of the bond fund may need to be sold at a loss, with more shares sold to meet a given spending objective.

This triggers sequence risk and locks in losses. Immunization only works if interest payments can be reinvested at a new higher interest rate to compensate for capital losses. But not all the funds are fully reinvested when a spending goal is met, so reinvestment risk and interest rate risk do not get neutralized.

The return on remaining assets would need to be even higher to keep the retirement liability funded. Immunization is harder when there is also a spending goal to support.

I favor an alternative approach of using individual bonds in a retirement income plan. A retirement income bond ladder can be structured so the cash flows provided through coupons and maturing face values will provide a steady and known stream of contractually guaranteed income for the ongoing expenditure needs in retirement.

Cash flows from the bonds are matched to fund desired expenses at desired dates. Interest rate risk can be ignored for the retirement expenses that have been matched with these dedicated assets.

Sequence risk is reduced because there is less risk of assets being sold at a loss. Rebalancing may be required in terms of extending the length of the bond ladder as time passes to cover future expenses, but the complexities involved in an ongoing effort to match durations can be better avoided.

Retirement income bond ladders generally take the form of Treasury bonds to minimize the possibility of default risk. But for those seeking higher yield by accepting some credit risk, newer ETFs such as Guggenheim Bulletshares and iShares term-maturity funds have cropped up as a pool of corporate bonds sharing the same maturity date.

For a household retiree, maximizing investment returns is not the goal; the goal is to meet expenses. Paper losses on individual bonds do not have to be realized if the bond is held to maturity.

While the retiree misses out on the opportunity to buy the bond at a lower price later, this cannot be known in advance. It is always unfortunate to buy bonds and then see the price drop due to rising rates.

But if the initial purchase allows the retiree to meet their retirement objective, then it is a successful purchase, no matter what interest rates subsequently do.

Retirees who realize that it is nearly impossible to predict interest rate fluctuations can take comfort in knowing that individual bonds allow them to enjoy retirement and ignore subsequent interest rate fluctuations.

Ignoring interest rate fluctuations is not possible with a bond fund strategy that has to make frequent adjustments to the portfolio’s duration in order to immunize against interest rate risk.

The difference between a traditional bond ladder as an accumulation tool and a retirement income bond ladder, is that with a traditional ladder, the cash flows received as coupons and face value are reinvested to purchase new replacement bonds at prevailing prices that extend the ladder and keep its length relatively constant over time.

With a retirement income bond ladder, the cash flows received are spent on planned retirement expenses. A retirement income ladder will naturally wind down if other assets from outside the ladder are not used to extend it further as time passes.

When an investor purchases an individual bond and holds it to the maturity date, the return is precisely equal to the prevailing interest rates at the time of purchase.

This is because the price paid to purchase a bond fluctuates so the return it provides to the investor matches the yields provided by bonds with similar characteristics for maturity date, credit risk, liquidity, and tax status.

Many investors would prefer to own bonds through mutual funds or exchange traded funds (ETFs), rather than making outright purchases of individual bonds.

The returns of such funds are based on two factors: current interest rates and future changes in interest rates. If interest rates are low, bond returns will follow suit both because the bonds in the fund are offering low yields, and because interest rates may be more likely to move up, rather than down, which would result in capital losses for the bonds held in the funds.

As we have discussed, changing interest rates lead, in turn, to capital gains or losses for investors. For professional bond traders, rising interest rates would be a serious problem for someone who had just purchased a long-term bond.

Most traders have no intention of holding bonds to maturity and will realize capital losses on the subsequent sale. Interest rate increases might also force retirees owning bond funds into a position of selling shares at a loss in order to meet retirement expenses.

For a bond portfolio that is not fully immunized, this triggering of sequence of returns risk can create irreparable harm for retirees.

I would argue that it is much easier for a retiree to ignore unrealized capital losses on an individual bond than for a professional trader or retiree needing to sell bond shares to meet expenses, because the individual bond is bought with the purpose of being held to maturity to provide a desired amount of income at that date.

Exhibit 1 quantifies this point. If interest rates are at 2% when a thirty-year bond is purchased, but then subsequently rise permanently from 2% to 3% during the first year the bond is held, the household retiree is sitting on an unrealized capital loss for the next twenty-nine years.

After one year, the bond price fell to $816, representing an 18.4% loss. Nevertheless, the bond continues to pay its 2% coupon payments and at maturity will repay the $1,000 face value.

As the maturity date slowly approaches, the unrealized losses slowly dissipate. The bond price gradually returns to match its face value.

The full recovery will happen at the maturity date when the final cash flows are received as expected. In this way, a household investor can be justified in ignoring those unrealized capital losses on the bond as they will not be realized if the bond is held to maturity.

Exhibit 1

30-Year Maturity Bond with 2% Coupons and $1,000 Face Value Ongoing Price of Bond if Interest Rates Stay at 2% and if Interest Rates Rise to and Stay at 3%


Click here to download Wade’s fact sheet, “What Is a Bond and How Does It Work?”

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