Anxiety prevails among fixed income managers over the prospects of rising interest rates and what it will do to their product’s reputation as a “safe” investment. Although the Fed recently signaled that it will not be raising rates immediately, the specter remains for investors who thought they were buying safety only to see their bond funds systematically erode as rates start to rise.
Many investors do not understand the counterintuitive nature of the inverse relationship between interest rates and bond values. Those who looked to bonds to protect their portfolios from the volatility of 2008 probably do not realize that the value of their bond portfolios will get hammered as interest rates rise. They assume that the lower volatility of bond funds means that their portfolio cannot lose value, which of course is not true. In fact, some bond fund vendors are beginning to issue warnings to customers that they should consider diversifying out of bond funds so the hit will not be quite so bad when the rates actually begin to climb from their current historic lows.
How bad can the hit be? A Schwab analyst suggests that, for bond portfolios with an average duration of five years, every percentage point rise in interest rates will cause the portfolio to drop in value by about 5%. There are a lot of technical assumptions behind that estimate, but it gets the point across.
Investors holding bond funds because they think they will be shielded from market fluctuations will be sorely disappointed, but not all bond investors will be hurt by rising rates. For example, retirees (or anyone else) buying fixed income to create predictable cash flows by laddering individual bonds and holding them to maturity will not be harmed by the intervening paper losses on their bond holdings. In fact, these bond investors may welcome cheaper bonds because they will make the cost of continuing the cash flows cheaper. By holding individual bonds instead of bond funds, investors who need to generate income from their portfolio can actually take advantage of rising interest rates and immunize their cash flows. College textbooks, both old and new, refer to the idea of holding bonds to produce cash flows as a “dedicated” portfolio strategy.
The Tale of Two Bond Investments
Investors generally gain exposure to fixed income either through funds or through individual securities. Bond funds and individual bonds serve fundamentally different roles, particularly for retired investors looking to generate income from their portfolios. Bond funds are designed as total return vehicles that seek to deliver lower volatility than stocks. The goal is to grow faster than withdrawals. However, the underlying characteristics of bonds are lost when they are aggregated in a single portfolio that serves thousands of clients. Although bond funds have low volatility, this doesn’t mean that they can’t lose money, which is exactly what will happen in the short run as rates rise. An investor would still have to sell shares in order to generate income, magnifying the negative effect of reverse dollar cost averaging.
The unique characteristics of individual bonds, on the other hand, can be engineered to deliver predictability along with low volatility. The amount of coupon interest and the timing of maturities for individual bonds are known when the investor buys the bond. So with a little timing, you can match the cash flows using the coupon and redemptions so that the portfolio will be completely immunized from changes in interest rates (since you hold the bonds to maturity) and perfectly match the duration of the income stream regardless of the type of shift in the yield curve.
Liability Driven Investing for Individuals
It used to be that individuals could rely on a pension from their employer to deliver predictable retirement income. Now, most individuals are left to their own devices to generate income from their portfolio. But the pension fund and the individual face the same challenge, building a portfolio to match the projected future income stream. In the institutional investing world, this approach is referred to as “liability driven investing” (LDI), also called goals-based investing
LDI can be implemented with individuals through dedicated (cash-matched) bond portfolios. The idea of a dedicated bond portfolio is to synchronize bond maturities and coupon payments to precisely match future cash flow needs and then hold the bonds until they mature. The cash flows, of course, are the withdrawals retirees must make each year to pay their living expenses. Individual bonds can supply perfectly timed cash flows year after year, without missing a beat. That is why they are called “fixed income” instruments.
Immunization and Predictability
Like its cousin the bond ladder, a dedicated bond portfolio is immunized against rising interest rates because the individual bonds are held to maturity. The value of the portfolio itself is not protected from rising interest rates, but the cash flow stream produced by the bonds is protected. By taking this cash-generating portion of the portfolio off the table risk is nullified where it counts.
Providing predictable cash flow is precisely what a dedicated portfolio is dedicated to do. In fact, holding U.S. Treasuries, agencies, CDs, and TIPS to maturity is probably the closest thing to perfect predictability that exists when it comes to future cash flows. Unlike a bond fund, retirees do not have to worry about what will happen if interest rates are up (and their portfolio value is down) just when they have to sell to get cash for living expenses.
Utilizing dedicated bond portfolios also avoids nearly all the classic risks associated with bonds. As already pointed out, market risk due to rising interest rates is eliminated because the bonds are held to maturity. Reinvestment risk is eliminated because the cash is not reinvested–it is withdrawn and used for living expenses. Default risk can be nearly eliminated by using CDs, Treasuries, and agencies (using AAA rated corporates or munis would carry a low default risk but not eliminate it because defaults do occasionally happen). Inflation risk can be reduced by building inflation adjustments into the target income stream or eliminated entirely by using TIPS.
Consider a couple who retired on January 1, 2010, with a $1 million nest egg. Assume their advisor recommended a 60% stock/40% bond allocation with an initial withdrawal rate of 5% increasing each year with inflation. The couple withdrew $50,000 for living expenses for 2010. If inflation during 2010 turns out to be 3%, they will expect to withdraw $51,500 in 2011, and so on.
To generate and protect the future cash flows regardless of market performance, the couple could buy $400,000 in individual bonds and hold them to maturity. Each bond would supply income in two ways: the coupon interest it produces each year plus its redemption value when it matures. These cash flows are known in advance and would arrive as scheduled, regardless of what happens to interest rates.
The trick is to buy the bonds in just the right amounts and maturities so that the total cash flows match the withdrawals needed for each year. An income stream starting at $51,500 and growing at 3% per year would add up to $457,955 over the next eight years. These are the liabilities that drive the investment, hence the moniker “LDI.”
The table above illustrates an example of a set of bonds that would supply this income stream. At current low yields on CD’s and TIPS (about 2.9%), this bond portfolio would cost $401,068. But its cash flows sum to $458,474, matching the annual targets nearly perfectly (bonds must be bought in $1000 increments, so the match cannot be exact).
Once the dedicated bond portfolio is in place, it will provide cash flows for the withdrawals in just the right amounts at just the right times. As each year passes, the same 8-year time horizon of protection can be maintained for as long as needed by adding a new bond with an 8-year maturity if desired. In practice, the entire portfolio would need to be re-configured to adjust for the cash flows from the new bond but this is the idea. Doing it every year over a lifetime would be the equivalent of self-annuitizing.
There is nothing sacred about eight years. Other horizons can be used (5 to 10 year are common for retirees). At today’s yields, each year of cash flow takes about a 5% allocation to fixed income, assuming the initial withdrawal rate itself is at or below 5%. For instance, if the couple had wanted a 30% allocation to fixed income, they could have secured about six years of income; a 50% allocation would buy about 10 years of income. Most retirement portfolios’ fixed income allocations fall into a 30% to 50% range, with 40% being the most popular.
The Impact of Rising Rates
At higher interest rates, the cost of funding the cash flow stream in our example would drop. This is why personal investors following this strategy might welcome a rise in rates.
To project the impact of higher rates, assumptions must be made. Starting with the base case of current rates, the same analysis was done assuming a parallel shift in the yield curve and using yields higher by 0.5%, 1%, 1.5% and 2%. The table above tabulates the results.
In the Base Case of current rates, the cost of the portfolio ($401,068) was about 87% of the 8-year cash flow it produced ($458,474). But if rates rose by 2%, the cost would be $370,426 or about 81% of the same cash flow. That represents a drop of about 8% for the cost of the overall bond portfolio.
Imagine that interest rates dropped by 2% immediately after the investor purchased the portfolio. Although the paper losses would be significant at more than $30,000, notice the income delivered by the portfolio remains unchanged. This same rate change would impact a bond fund values in a similar way. But there is a difference: the investor using a total return approach would have to sell shares in order to generate enough cash thereby selling a depressed asset. This sequence risk magnifies the impact of the withdrawal on the portfolio.
In fact, rising interest rates will be seen as a blessing for investors who use a dedicated bond portfolio. As shown in Table 2 (above), rising interest rates make it cheaper to buy future income. As income is consumed out of the portfolio each year, investors will likely look to extend the portfolio time horizon back out to the original (8-years in the case above).
Rising interest rates do indeed cause bond values to fall. For investors who utilize bond funds in a total return approach to generating income, rising rates may well continue the whipsaw effect that started in their equity portfolio in 2008. Portfolios of individual bonds dedicated to generating cash flows with redemptions and coupon interest will fare much better. The simple idea of precision laddering bond maturities to match income needs solves many of the problems that rising rates and fluctuating markets can cause. Rising rates mean lower costs to provide the same cash flows, and will be viewed as a silver lining for smart bond investors.
Stephen J. Huxley, PhD, is chief investment strategist and Brent Burns, MBA, president of Asset Dedication, LLC, in Mill Valley, California. They are both founding partners of the firm and can be reached via www.assetdedication.com or 866-535-0897.