Forget The Insurance Company, Build Your Own Annuity

Includes: HYG, JNK, LQD
by: The Financial Lexicon

As tens of millions of baby boomers approach retirement, investments deriving income will likely continue to be a hot topic. This might also be exacerbated by the fact that yields on savings accounts, money markets, FDIC insured certificates of deposit, and government bonds are near historic lows. Furthermore, the psychological damage brought about by the Great Recession, the “Flash Crash” of 2010, and the recent financial market volatility will likely cause investors nearing retirement to favor to some unknown degree assets providing income with relative safety to principal, as opposed to assets deemed “risky.”

All too often I read articles focusing on whether investors, especially those nearing retirement, should focus on dividend paying stocks or annuities to drive income in retirement. Often the articles conclude that some mix of the two is most appropriate. I would like to address the annuity side of the debate.

Rather than staking your future on a contract between you and an insurance company, why not create your own annuity? If one is willing to put in the time and effort, creating your own annuity is within reach. We, as a society, spend so much time researching how to spend our money, but in terms of how to grow the money or live off the money, we are willing to hand it over to an insurance company, or an investment advisor who will hand it over to an insurance company (and take a fee for being the middle man), rather than putting in the effort ourselves. For those willing to put in the research and create your own annuity by buying individual bonds, you will not only retain absolute control over your investments and avoid the counterparty risk associated with the insurance company, but also avoid all sorts of convoluted rules and fees that come with annuities. Do yourself a favor and create your own annuity.

Here’s how to do it: Buy individual bonds and plan to hold them to maturity. Whether you actually hold them to maturity or not will be determined by a number of events, but when you choose a bond to buy, do so with the intention of holding it to maturity.

By buying individual bonds and planning to hold them to maturity, you will not only avoid the complicated rules and fees associated with annuities, but you will also avoid the risk of interest rate movements permanently damaging your principal (the type of risk associated with a bond fund or a bond ETF). Since the managers of bond funds and bond ETFs (exchange traded funds) trade the underlying securities of those funds, it is possible that in a period of rising rates, or a period in which rates are extremely volatile and your fund manager makes some poor decisions, that your principal will decline and not recover…ever. However, by buying individual bonds, you take away that risk. As long as the company does not default, your bond will mature at par (100 cents on the dollar).

It is true that buying individual bonds will not necessarily shield you from the risk of inflation. However, that risk will also exist with many annuity products as well as bond funds and bond ETFs.

Once you decide to buy individual bonds, you must pick a broker that provides low enough commissions to make it worth your while, as well as an inventory of bonds or access to dealers with an inventory of bonds that are diverse enough to shape your portfolio. In my experience, Vanguard has access to a huge inventory of individual corporate bonds as well as Treasuries at reasonable prices. Commissions are one area Vanguard doesn’t seem as strong as some competitors. Fidelity offers commissions at just $1 per bond. However, in my experience, Fidelity’s inventory of corporate bonds and the prices at which they are able to get me those bonds tends to lag behind Vanguard’s. In terms of Treasuries, it’s hard to beat Fidelity’s $0 commission for all clients and spreads no larger than Vanguard’s. So, for the majority of individual investors, Fidelity seems like the place to purchase Treasuries.

In terms of how to choose which corporate bonds to buy, FINRA’s website can be quite helpful, providing a variety of details about different bonds. Among other things, the site allows you to type in an equity symbol and view all the bonds available for that company. In the details page for each bond, you can access the CUSIP number for the bond (equivalent to a stock symbol for equities), which is useful when searching for a fixed income security on your broker’s website.

Also, Morningstar provides numerous details on corporate bonds, including charts, maturity schedules, coupons, yield-to-maturity, amount outstanding per issue, and last price. Johnson and Johnson’s (NYSE:JNJ) Morningstar page, for example, provides these details on 25 different issues, as well as the ability to drill down into each bond and find further details such as call and put features, spread to Treasuries, and the currency in which payments are made.

Finally, beyond researching companies you are already aware of and potentially purchasing their bonds, I have found it useful to look up the underlying holdings of various bond funds and bond ETFs. At the time of this writing, Vanguard’s website provides the portfolio holdings of its bond funds. Also, among other bond ETFs, you can look up the holdings of the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA:LQD), the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG), and the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK).

In future articles, I will examine how to hedge your fixed income investments in order to minimize corporate default risk and inflation risk, as well as examine the role Treasuries could play in your portfolio.

Disclosure: I am long JNJ.

Additional disclosure: I have brokerage accounts with Vanguard and Fidelity. I am long JNJ bonds.