The Hunt For Duration-Matched Bond Funds
In basic asset allocation for wealth accumulation, matching assets to liabilities is not a priority. The retirement liability (the desire to meet a spending goal in retirement) is not part of the analysis.
Investment decisions made in an assets-only wealth management framework (where the goal is to maximize wealth subject to an acceptable volatility) often differ from those made when the goal is meeting ongoing spending needs. In an assets-only framework, a bond portfolio’s duration is more likely to be determined by the investor’s willingness to accept volatility, and the risk-return tradeoffs for increased duration.
The goals of this chapter are ultimately to find a way to match the bond portfolio to retirement expenses and to look in-depth at how bonds can be used to meet retirement goals. Hence, our discussion of bond funds (mutual funds or ETFs), which can be chosen in such a way that their duration matches that of the retirement liability, helping immunize the retiree against interest rate risk and bond price volatility.
When choosing a bond fund, it is important to note that bond returns are primarily driven by their term/duration and credit risk. Active management for bonds generally does not add returns, especially after accounting for fund fees. The best choice is a low-cost fund with appropriate duration and credit risk for your situation.
Bond funds provide advantages through greater diversification of bond maturities, as well as the possibility of trading more cheaply within the fund without having to pay retail markups. Bond funds may also provide easier handling for taxes and simpler reinvestment of interest payments.
On the matter of diversification, it is not an issue for Treasuries. Credit risk is minimal, and any such risk would likely affect Treasuries in a similar way. For corporate and municipal bonds, however, diversification within the fund will help mitigate credit risk.
In addition, funds may enjoy better pricing as institutional traders since trading costs for individual investors in these markets may be higher. For typical household investors, holding individual bonds for Treasuries is more practical and beneficial than for corporate or municipal bonds.
This approach presents one major difficulty: determining the duration of the retirement liability. With each passing year, remaining life expectancy decreases, but not on a one-to-one basis.
In practice, duration matching for a retired household will be highly complex and not necessarily practical, making immunization from interest rate risk an insurmountable obstacle for a household to accomplish on their own.
It requires constant monitoring and rebalancing of the bonds to match the desired duration as interest rates change and bonds mature. As it is, these concepts have not fully penetrated the wealth management world, and decisions about holding bond funds are still typically made on an assets-only basis.
That being said, at least two companies have created mutual funds to provide duration matching with bonds. First, Dimensional Fund Advisor’s Target-Date Retirement Income Funds define the retirement liability specifically as a goal to support inflation-adjusted spending for twenty-five years after the target date.
Using TIPS to support the inflation-adjustment goal, they can create a portfolio with a duration that matches their defined liability from a given target date and hedges inflation and interest rate risk.
The other company is BlackRock, whose CoRI Retirement Indices develop a bond portfolio that hedges the price of a lifetime income annuity with a 2.5% cost-of-living adjustment, locking in the potential amount of income available from annuitizing a portion of your portfolio without actually purchasing an annuity.
Income goals are survival-weighted rather than fixed at 25 years, and they grow with a 2.5% COLA rather than the CPI. But the underlying concept of hedging interest rate risk by defining a retirement liability and then matching its duration to that of the supporting assets is the same.