I was telling my wife that I was going to write about bond laddering and she got this puzzled look on her face and said, “Ooh, that sounds sexy” using the snarky voice she reserves for things that sound the most boring. While I can’t fault her judgment on the sexiness of investing in bonds, I also know how much she enjoys having enough money to live our lives the way we choose, and not in some way imposed by the vagaries of chance. That only happens by planning and proper execution. And so . . .
Several months ago I wrote a post describing why I keep 5 years of cash available for living expenses. To read that post, click here. In short, I keep 5 years of what I calculate my minimum required expenses to be (which is about 3 years of my “desired standard of living” expenses) in very liquid assets. This post will discuss what I do with that money (when I’m not spending it).
We’ve all read the old saw about keeping 6 months living expenses in the bank “just in case”. There are those in the FIRE community who, for their own reasons, don’t even do that; choosing instead to fund their lives in a more ongoing, real-time sort of way. That is something I could not be comfortable with. My parents were children of the depression (I am an Oldster, after all) and so I keep at least one year’s expenses in cash, in the bank. If the situation allows it, and the interest rate is sufficiently attractive (a hard thing to find these days), I will break this cash into 6 months expenses and a 6 month certificate of deposit. The idea here is not to make any significant money on your immediate cash needs, but to at least bring a little income in on that money where possible. You can find decent checking accounts that will yield from 0.5% to 1% or so if you look around. At the moment a 6 month cd at most banks does not yield any more than a decent interest bearing checking account, so I’m not using that option.
So we have a year’s worth of cash in the bank, freeing us up from having to use any of our invested assets as living expenses. But what do we do with the remainder of the cash hoard? In two words: Bond Ladder. But not the type you are thinking of.
For those of you who have done any significant reading on retirement finances, the notion of a bond ladder will be familiar. In short, it is a series bonds of increasing duration, that mature as your need for cash approaches. For instance, if you need $25,000 per year in income, you might have that much invested in bonds that mature next year, and another $25k in bonds that mature the year after that. Insurance companies have been doing that sort of thing forever as a way of assuring they have enough cash on hand to meet future payment obligations.
But for average investors buying individual bonds can be a difficult and expensive proposition, and can be a bit on the risky side, as well. Because bonds are generally traded over the counter, you run the risk of over-paying due to the spread and retail mark-up. Additionally, the fewer bonds you own, the more exposure you have if an issuer delays payment, or even, horror of horrors, cannot pay. This is how bond mutual funds and etfs came into existence. The market realized there was a need for a product that could spread default risk over a large number of issues and therefore, minimize the risk of any single default having a disproportionate effect on an investor’s portfolio.
The problem with most bond funds is interest rate risk. If you buy a fund paying 1.5% for $10 per share today and tomorrow interest rates rise, then the price of your bond fund will drop in order to compensate new buyers for the increased interest rate. You though, end up owning an asset that is worth less today than it was yesterday. Theoretically, if you hold the fund long enough, the increased interest rate will make up, to some degree, for the loss in share price. But if you need your capital on a date certain, you run the risk of the shares you paid $10 for being worth less than that when you need the money.
This is where the individual bonds are more attractive. You buy bonds with a face value of $25k and which pay 1.5% interest and when interest rates rise, if you hold those bonds to maturity, you still get your $25k back, in addition to the interest the bond pays. What you may lose in rising interest, you gain in certainty that your cash will be ready when you need it.
For the last few years we have had available to us a product that bridges these two worlds: Defined Maturity Bond Mutual Funds or ETFs. These are funds are comprised of many different bonds, all of which mature at roughly the same time. So you can buy $25k worth of shares, and whether interest rates rise or fall, you make some interest based on bonds purchased by the fund and, perhaps more importantly, you get your capital back. For this service companies like iShares or Guggenheim (the big players in this space at the moment) will charge you fees of 0.10% to 0.25% annually (not insignificant in this low-interest rate environment, but a reasonable price for relative certainty of capital return).
So, how do you go about putting one of these modern bond ladders into place? Think of it like this: You have expenses of $25,000 per year and you are keeping one year in cash in the bank. You have $100,000 for the four years following this year and you want to invest in bonds that mature in 2019, 2020, 2021 and 2022. You might think about this type of arrangement:
$25,000 invested in IBDK – iShares Defined Maturity Corp. Bond ETF Maturing in 2019 paying 1.84%
$25,000 invested in IBDL – iShares Defined Maturity Corp. Bond ETF Maturing in 2020 paying 2.15%
$25,000 invested in IBDM – iShares Defined Maturity Corp. Bond ETF Maturing in 2021 paying 2.40 %
$25,000 invested in IBDN – iShares Defined Maturity Corp. Bond ETF Maturing in 2022 paying 2.69 %
Note: There are many different flavors of Defined Maturity Bond Funds and ETFs. I’ve selected corporate bonds for the above example, but here are high risk corporate bond funds, municipal bond funds, government bond funds, and others you can use to tailor to your risk/return appetite.
When the above bond fund matures in 2019 you’ll have approximately $25,434, including interest (taxes not calculated). You can put this in your bank account for that year’s cash needs, or, if fate has smiled upon you and you don’t need the money for that year (due to your frugal lifestyle, side hustle or finding that Mickey Mantle rookie card in the attic) you can reinvest it in IBDO maturing in 2023 and paying 2.9% as of today.
There are some risks using this type of bond ladder. Most are interest rate related risks involving bonds being redeemed early and the fund not having time or opportunity to reinvest the proceeds before distribution. So you might make a few hundredths of a percent less in return than you think you will. Also, there is the very rare case of a bond defaulting. If this happens, you may not get quite all of your capital back at distribution time, but depending on the circumstances of the default, you may get a future payment once things resolve. This is why being in a broadly diversified fund with many different bonds from different issuers is an advantage.
The whole point of this exercise is being able to weather financial storms and market drops. If you have the cash on hand to survive for several years, then when Mr. Market does take a nose dive, you won’t be forced to liquidate valuable investments at fire sale prices. You can wait for crazy markets to return to sanity before selling anything. If we can make a few bucks along the way while we wait, so much the better.
Until Next Time, FIRE On! – Oldster