A Bond-Based Financial Planning Framework
The following is excerpted from Bonds, Second Edition by Hildy and Stan Richelson. Copyright 2011 by Hildy and Stan Richelson. Published by John Wiley & Sons. Used with permission.
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There are two times in a man’s life when he should not speculate: When he can’t afford it, and when he can.
Like Rodney Dangerfield, bonds get no respect. Their advantages of predictable growth and cash flow are woefully underappreciated. We believe that plain vanilla bonds have proven themselves to be the best investments available, and we wholeheartedly agree with Andrew Mellon’s prescient late-1920s observation that “gentlemen prefer bonds.” We believe that ladies should, too.
Mellon’s statement was memorable, although a bit too pithy. Bonds are an extremely diverse financial category. They come in all denominations and maturities, from ultra-safe Treasury bills to risky junk bonds and unfathomable CMOs, and they serve a variety of needs and purposes. You don’t simply buy “a bond” just as you don’t simply buy “a car.” There are important choices involved, and you need to understand the specific reasons for your intended purchase, what you are going to use it for, and how long you intend to keep it.
Investors tend to buy bonds with different strategies in mind. The All-Bond Portfolio is a strategy for investing in very conservative, plain vanilla bonds in order to preserve principal and receive a steady stream of cash to support the life objectives and financial needs of the investor. This is in accord with Richelson Investment Rule 1: Define your objectives and Richelson Investment Rule 3: Don’t lose money.
Create cash flow with bonds
We believe that cash flow is the key to financial planning and retirement planning for individual investors. You can’t eat gains and losses but you can live on cash flow. In this section, we explore the reasons to use bonds to create the needed cash flow.
Focus on cash flow not performance
Unlike most financial advisors, we don’t track bonds in terms of their yearly unrealized gains and losses. Unless there is a good reason to sell a bond, such as a significant decline in its credit quality or a change in a client’s needs or financial situation, we generally hold bonds until they come due. With this buy and hold strategy, the ups and downs of the price of your bonds before they come due is meaningless. In Wall Street parlance, it is just noise. In our view the concept of performance (tracking yearly unrealized gains and losses of a bond portfolio measured against an index) is pointless.
Instead of performance, we focus on cash flow – how much cash will a portfolio of bonds produce each year on an after-tax basis. You can determine your yearly cash flow from a portfolio of bonds quite precisely and easily by adding up the interest coupons that the bonds will pay twice a year. Fidelity Investments and some other broker-dealers provide a 12-month estimate of cash flow with their monthly statement. If you are not spending all of the cash, you can reinvest the surplus in additional bonds. You can also easily determine how much tax you will pay on your interest income each year. You will see unrealized gains and losses reported on your bond portfolio statement as interest rates move up and down during the year. However, these gains and losses will not affect the cash flow from your bond coupons. Your coupons stay fixed no matter how bond prices fluctuate. You can live on your cash flow.
Buy Cash Flow, Not Diversification
Now compare the return on a portfolio of bonds to a portfolio that includes an assortment of the following investments: stocks, real estate, commodities, gold, hedge funds, private equity, and other investments that have unpredictable cash flows and never come due. How can you plan to live in retirement on a portfolio of these volatile investments whose value and cash flow is unpredictable over the short-term or long-term?
It may be comforting to run complex financial planning programs that spit out 50 pages of detailed numbers and Monte Carlo programs that provide 10,000 or more scenarios based on past financial scenarios. It may also be comforting that based on these programs you are told that you can safely withdraw somewhere between 4% and 6% of your portfolio a year after retirement. However, we are living in a financial environment that is the most dangerous since the Great Depression of the 1930s. With the present uncertain times, as seen from the vantage point of 2011, how can you comfortably look back to the past for substantial guidance of future outcomes? Similarly, how can you determine the cash flow on investments, other than high-quality bonds, when the best economists are in substantial disagreement as to whether we will have a massive deflation as occurred in Japan for the last 21 years or a rapid episode of inflation as occurred in the United States in the 1970s? Events like the 2011 earthquake and tsunami in Japan add considerably to the uncertainty of the future.
The conventional wisdom is that a portfolio of diversified asset classes will outperform a portfolio of bonds while minimizing risk. Most investors believed that to be true until the crash of 2008, when all asset classes, including U.S. and foreign stocks, real estate, mortgage securities, and commodities, crashed together. On the other hand, a portfolio of high-quality bonds held their value and provided a reliable and consistent cash flow during and after the crash. In fact, as a result of the crash the price of Treasury bonds went up dramatically. A deeper understanding of risk resulted from the crash of 2008.
The clearest analogy to cash flow from bonds is the paycheck with which most of us are familiar. A bond portfolio providing a steady stream of interest payments is like a paycheck you would receive from working. It is a defined amount that you can count on. If you had a blended portfolio of many asset classes instead, the amount you could safely withdraw would become uncertain. You could not count on a set amount unless you were prepared to invade principal in the face of down markets. Market volatility is not a problem unless you are required to sell assets when the market is declining. If you are counting on a specified withdrawal, you might quickly deplete your principal if you face years of nonexistent returns or losses, such as we experienced between 2000 and 2009. “You may need more flexibility in your spending analysis,” suggests Fred Amrein, a financial planner at Amrein Financial in Pennsylvania.
Get cash flow, not hoped-for returns
We have heard the argument endlessly that a portfolio of high-quality bonds will not pay out enough cash flow to support you in your current lifestyle after you retire. You can calculate the return on bonds and determine whether this is true. If so, you then need to decide whether you believe that some other portfolio of investments will provide higher consistent returns. You then need to evaluate the promise of high returns from this alternative portfolio and ask yourself these questions: What is the basis for your belief? How certain is your conclusion?
In psychology, there is a concept called wish fulfillment that says “I need this to be so and, therefore, it will be so.” Are you prepared to pay the price if it is not so? And how high is that price? Many investors are essentially throwing a “hail Mary pass” when they invest in stocks and other high-risk investments in the hopes of investment success. We believe that the fewer resources that you have the more conservative you should be with your investment selection because you have less room for error. Remember Richelson Investment Rule 2: If you can’t afford the risk, don’t play.
Inflation and cash flow
We are always challenged with the argument that future inflation resulting in higher interest rates will overcome the merits of the All-Bond Portfolio. But before you close the book on bonds for this reason, you need to look at the deeper meaning of inflation and then at our strategy to turn inflation and higher interest rates to your benefit.
At the outset, we agree that inflation does hurt your buying power. However, an investment in stocks doesn’t cure the inflation problem. When inflation exploded in the 1970s, stocks declined by about 50% in 1973 and 1974. One substantial cause of this decline was high interest rates that accompanied that inflationary era.
Our solution to the inflation problem is to put in place a bond ladde. Briefly, a bond ladder is a strategy to have one or more bonds come due in multiple years. For example, if you have $100,000 to invest, you might have a $10,000 bond come due in each of 10 different years beginning in 2012 and ending in 2021. If your bond ladder is in place and inflation breaks out and results in higher interest rates, you will be able to increase your cash flow by reinvesting your bond proceeds as they come due and your excess interest income in higher yielding bonds. For example, if you are getting a 4% return and interest rates go up over time to 6%, your cash flow will increase by 50%. Thus, if your bond ladder is in place, inflation resulting in higher interest rates is your upside case, and not a reason for concern.
Now let’s take a look at what the inflation rate as measured by the Consumer Price Index (CPI) really means. There really should be two CPIs, one for a middle-class family of four earning around $50,000 to $60,000 per year and another CPI for rich people. President Obama says you are rich if your family earns more than $250,000 per year. The CPI is heavily weighted to real estate, food, and oil products. If the CPI goes up, it really hurts the middle-class family. However, it doesn’t hurt the rich family because the percentage of their income that they spend on food and oil products is a very small percent of their income. As to real estate, they already own a home. So why should rich people worry about inflation? We think that the possibility of inflation should not stop them from investing in bonds, particularly if they have a bond ladder.
Cash flow in retirement
If you are spending some of the principal returned to you from maturing bonds, then you will be reducing your overall cash flow in the future. If you are retired, you may prefer to have greater cash flow currently even if the principal declines. However, it is important to realize that the consumption of principal results in the gradual diminution of the portfolio’s ability to generate cash flow.
Though you may think that planning on living on the interest payments from your bond portfolio may crimp your style, accepting what is – rather than what you hope might be – may encourage you to more realistically look at your options. You may have many sources of cash flow or few.
You may decide:
- Early retirement is not in the cards for now if interest rates are very low.
- Start a small business you can manage in semi-retirement.
- Invest longer-term despite market fluctuations in value to achieve a higher return.
- Consider living in a lower-cost community.
In summary, we believe that cash flow from bonds is the key to successful investment planning and retirement planning.