Some conservative investors may prefer a retirement income strategy that protects their capital.
A popular way is to implement retirement income by investing in a portfolio of individual bonds of decent credit quality.
The strategy in brief:
- Deploy your capital in a portfolio of bonds of decent credit quality.
- Spend only the coupons distributed by your bonds on a semi-annual basis.
- You will get back 100% of your principal when the bonds mature.
- Reinvest your principal in the same credit quality bonds with the highest yield.
- Go back to #2.
There are a few advantages to this strategy:
- You may have an easier time assessing the fundamentals of the business of the bond issuer to assess its financial standing and probability of default than if you are investing in the equity/stock.
- If you do #1 well, the bond issuer has a contractual obligation to pay your coupon and principal back.
- You can ignore the daily price volatility. At most, you can focus on whether the company will default or their interest income paying ability.
- If you manage well, your capital is protected and can generate perpetual income for your family for generations.
Of course, every strategy has its downsides:
- Challenging to achieve proper diversification if your capital is more diminutive.
- You will have to manage the portfolio yourself, pass it to your spouse and heir, and hope they will know how to manage the strategy.
- Income may not keep up with inflation.
- Income is volatile due to reinvestment risks.
The reinvestment risk is less discussed, but how significant is the impact? I think it is big enough, going by history, and it significantly impacts whether your income can keep up with inflation.
Bond Yields Are Volatile Historically
The chart below shows the historical yield based on the buying rates of 5-year Singapore Government Bond Dealers:
This chart shows you roughly what the 5-year SGS bonds trade at. I pick the 5-year SGS bonds because that is usually a tenor that is not too short and not too long, which is popular among bond issuers and investors.
Retail investors would prefer to take some risk (but not too much risk) with corporate bonds to find the sweet spot between not too risky but a good yield.
However, given a certain credit quality, you can accept throughout your retirement, the bonds should roughly trade at a premium above risk-free bonds (in this case, the 5-year SGS bonds).
If the 5-year SGS bonds trade at a healthy yield, the corporate bonds trade at a healthy yield.
You can see that the 5-year SGS bonds once traded at 5.44%, but in 2002 that dropped to 1.74% before climbing back to 3.03% in 2006. In 2011, the yield dropped to 0.60% and currently, the yield is 2.75%.
The Impact of Yield Volatility on Retirement Income
If you wish to protect and not spend your capital, your income will be volatile, given the reinvestment risk.
The table below shows a case study of an investor who decides to retire at the start of 1988 by investing $2 million in a portfolio of bonds with a tenor of 5 years:
Instead of investing in SGS bonds, he decides to go out in the risk curve to search for bonds whose quality is good enough but give you a higher yield. I assume the investor can find a corporate bond with a 1.5% higher yield with decent quality whenever he or she reinvests.
The investor would return the $2 million principal every five years and reinvest at the prevailing yield.
You would notice that the investor retiring in 1988 will see his or her income fall from $138k to $39k today. If he or she needs all that $138,000 without much flexibility in spending, you can imagine how his or her plan would crumble.
Bond yields since the 1980s have been on a downtrend (with an R-square of 0.675). Even if bond yields are not in a downtrend, we can observe that the income is volatile.
Yet, in this strategy, the investor cannot sell part of his or her capital to smooth out his or her spending.
His income is deflationary, while the world is inflating away. He is losing his purchasing power massively.
Possible Improvements to the Individual Bonds Retirement Income Strategy
I try to dig hard inside my head on how to make this strategy work better:
- Be more conservative when planning how much you spend in the first year. Refrain from needing 100% of the income. This solution is challenging because how conservative should you be? Even if you spend half of the initial 1988 income, your income in 2022 would still be less than that. You have to be so conservative. However, put yourself in that investor in 1988. Could you have anticipated bond yields to be that low 34 years later?
- Be very opportunistic in identifying mispriced bonds yet with similar credit quality. This would help get a higher yield, but this strategy requires sophistication and more significant active management, and in truth, there is a limit to how much you can veer from the risk-free government bond interest rates.
- Reinvest in poorer quality bonds. Take on more risk reluctantly, but this comes with many problems, such as affecting whether you can keep your capital intact.
- Create a sort of bond ladder by spreading out your bond purchases. This will smooth out the reinvestment risk. But it doesn’t iron out the problem of irregular income and if the interest rate keeps going down.
- Don’t use a pure individual bond portfolio to derive income. The last one is the most plausible, but this would deviate badly from the strategy.
The individual bond portfolio retirement income strategy is weak because the investors are very reluctant to spend or reallocate the capital. There is also a selling-for-income limitation due to the bond quantum. Inflation may not move with bond yields in the lock step, which affects if your income would keep up with inflation.
These problems seem glaring enough, but I think many who implement the strategy try to be optimistic that they will always find bonds of good quality that yield similar to the yield when they first retire.
That is not always going to be the case.
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