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The Perils of Using Long Term Bonds for Retirement Income

Interest Rate Risk

The low interest rate environment has income-thirsty investors scrambling to find ways to invest their money with acceptable risk.  One temptation that I have seen many succumb to is investing in long term bonds.  This can be an extremely dangerous proposition, and my hope is that, after reading this blog, I can make anyone contemplating such a  strategy to seriously reconsider this decision.

The Source of Temptation

Today’s yield curve, which shows the interest rates for bonds of different maturity durations, increases from 2.27% on a 5 year AAA (highest quality, lowest risk) corporate bond to 5.11% on a 20 year AAA corporate bond.

 

 

 

 

 

 

 

 

It is not at all uncommon for long term yields to be higher than short term yields, and there are a variety of academic theories that explain this phenomenon.  The temptation is take advantage of this long term interest rate and live off the interest during retirement.  On the surface, this appears attractive as the initial level of income would be 5.11% which is much higher than some of the recommended withdrawal rates that are often discussed in the media, which are typically 4% or lower.  Here is a chart summarizing how this arrangement would play out in the eyes of an investor with $1,000,000 investing in 20 year bonds paying 5% interest per year:

Simply stated, each year the bond generates a 5% annual coupon (the cash the bond holder receives each year as an interest payment, which is assumed to be equal to the overall yield of the bond), which is in turn used to generate retirement income each year and spent to support lifestyle needs of the investor.  This process repeats itself, leaving the principal invested intact until the maturity of the bond in 20 years.

Sounds good, right?

Well, here are the problems with this strategy…

Problem #1:  Inflation

The plan, as originally envisioned by the investor, does not accommodate the effect of inflation on the expenses that they will incur during retirement.  If inflation were to occur under this plan, either a portion of the bond would need to be sold to create the cash that would be needed to pay for the higher cost or the investor would need to reduce their spending to the $50,000 of interest they would receive.

Using an inflation of 3% per year, the updated financial projection would look as follows:

As you can see, in column (D) the spending has changed from a constant $50,000 per year to an amount that increases at 3% per year.  Starting in year 2, spending exceeds the coupons received from the bond (i.e. the interest payments, shown in column (C)), so the investor must cover this difference by selling off a portion of their bond portfolio to get the cash to cover this difference.  The dollar amount of bonds sold equals the “net cash flow” shown in column (E), and the percentage of the bonds sold each year is shown in column (F).

So, by considering inflation you can see that we are no longer able to maintain the $1,000,000 of principal until the maturity date as we are forced to sell much of this principal balance to cover inflation.  As a result, in year 20 we only have $535,332 of principal available upon maturity instead of the $1,000,000 that we thought we would have when ignoring inflation.

One way to manage this is to start spending at a lower level.  So, what initial level of spending that grows at 3% per year can keep the $1,000,000 after 20 years intact?  The answer is $39,030, which is much lower than the $50,000 we initially planned on spending.  We would have to reinvest some of the coupon (the excess of the coupon over the spending) we receive in the early years of retirement into the bond and use this to offset the cost of higher inflation in later years.

Problem #2:  Interest Rate Risk

Holding all of your savings in 20 year bonds also subjects the investor to considerable interest rate risk; as interest rates rise, bond prices drop (see my prior blog for a more detailed explanation of this relationship), and given the low level of current interest rates bondholders have a significant exposure to the risk of interest rate increases in today’s environment.

To demonstrate this risk, here is what would happen if interest rates increase from 5% to 7.50% in the third year of retirement (building off of the previous example that included 3% inflation):

Now, comparing these results to those from the previous results may initially not look all that bad, as we end up with $430,307 at the end of 20 years instead of $535,332 – not a huge difference.  However, upon more careful examination, we can see that in year 3 the value of the bond portfolio drops from $998,500 in the previous example to 756,214, a 24% drop in value.  This can be a real problem if you encounter unforeseen expenses at this time; when selling more bonds, you would only receive $0.76 on the dollar.  Looking at this a bit differently, each dollar of bonds redeemed will consume 32% more principal than it would have if interest rates remained unchanged, a hefty tax.

Problem #3:  Inflation & Interest Rate Risk, Combined

Interest rates and inflation are highly correlated, meaning when one increases so does the other.  To examine the potential impact of this, let’s make more more enhancement to the prior analysis, and assume that when interest rates increase 2.50% that inflation increases 1.50%, from 3% to 4.5%.  Here are the results:

 

As you can see, the combined impact of higher interest rates and inflation are devastating, leaving only $161,997 in year 20 (enough to cover only approximately one more year of spending).

Parting Thoughts

Investing entirely in long term bonds, although tempting, is a high risk proposition.  Inflation and interest rates changes can have a dramatic impact on the long term success of your retirement income strategy. Instead, give serious consideration to:

  • creating a bond ladder (see my blog on this) that matches your income needs; this will reduce, and possibly eliminate, much of the interest rate risk.
  • TIPs, or treasury inflation protected securities, which adjust interest payments to the consumer price index, and therefore provide some protection against inflation.  However, this protection comes at a price; yields on TIPs are somewhat lower than other bonds.
  • inflation-adjusted immediate annuities or immediate annuities with a cost of living adjustment, which have the added benefit of providing longevity protection.

Posted by

John Bevacqua on March 15, 2012

Filed Under

Investing, Risk & Protection

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Investing entirely in long term bonds, although tempting, is a high risk proposition. Inflation and interest rates changes can have a dramatic impact on the long term success of your retirement income strategy.


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