A Retiree's Quest For A Good Bond Investment

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Includes: BBEPQ, CORP, FCOR, JNJ, LNGG, LQD, O
by: Ted Waller

Summary

Bonds are the gold standard for safety of income and return of principal.

Bonds are historically sought by retirees to meet their financial goals.

This report examines major types of bond investments on the parameters of income and safety.

I want what most newly retired people want: Lots of good, secure income for a long time, with a good-sized pile of money at the end to leave to my lucky heirs. I can't say this is the primary goal of every retired person, because like Jack Nicholson and Morgan Freeman in The Bucket List there are those who will pursue life ravenously and intensely regardless of the cost. But even in the movies most older people seem to require money for the plots to move forward. Maggie Smith and Bill Nighy don't get to stay at The Best Marigold Hotel for free. Come to think of it, Jack Nicholson in The Bucket List was a billionaire.

Bonds are a logical place to look because they are regarded as the most secure source of income available. They provide a regular income and guaranteed return of par value at maturity. There are four rules guiding this study:

  1. Income must be extremely secure.
  2. Principal will be returned at maturity.
  3. These are long term investments with a 5-10 year time frame.
  4. Inflation will be higher in the future than it is now.

Whether the fourth item comes to pass is not certain. I believe it is very likely, but its importance really comes from the outsized impact inflation has on bonds. Fixed income and inflation are a deadly combination over time. It would be less important if we were discussing an investment that has some ability to adapt to inflation.

There are far too many choices in the world of bonds to cover them all in one article. I chose to look at the opportunities available in some of the major classes.

Results

Investment grade vs. non-investment grade: According to Both Moody's and Standard & Poors, the important bond rating agencies, the other official term for non-investment grade is "speculative." The complete rating table is here. They have a higher rate of default. Outside of the oil sector we have not experienced a default spike for many years, but as this chart indicates they recur periodically:

Source: HighYieldBond.com

The investment I am looking for is not going to be anything described as speculative, so non-investment grade bonds will not be in the portfolio. Bonds do have a higher recovery rate than equity in bankruptcy but as bondholders in GM, Chrysler, Linn Energy (LINEQ), Breitburn (OTCPK:BBEPQ), and many others can attest, recovery is not a sure thing.

Bond funds: There are many investment grade bond funds available. The income is secure and would actually increase with a general rise in interest rates as new bonds replace the old, but they cannot guarantee security of principal. If interest rates rise they will suffer a loss in value because of the tight relationship between price and interest rate. On top of this, the low yield of bond funds today means that even the low fees they charge can be a burden. There are respectable ratios such as the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD) with fees of .15% and yield of 3.20% and PIMCO Investment Grade Corporate Bond Index ETF (NYSEARCA:CORP) with fees of .20% and yield of 2.80%, but also the Fidelity Corporate Bond ETF (NYSEARCA:FCOR) with awful fees of .45% on a yield of 2.85%.

Zero coupon bonds: Zeros have a higher yield than their semi-annual paying brethren, but provide zero income until maturity. Still, the IRS requires you to pay tax on the income each year even though no interest is distributed until the maturity date. These bonds obviously don't meet a need for current income.

Corporate vs. municipal vs. government bonds: At this point the field has been narrowed to individual investment grade bonds. The table below from Fidelity shows the current rates available for various types.

The yields for municipal and U.S. Treasuries are simply not meaningful. Even adding in the tax exemption benefits the return is less corporates. Furthermore, I can get a 5 year certificate of deposit (CD) from my local credit union that yields 1.75%

Corporate Bonds: We are now down to investment grade corporate bonds. The highest yield for the 5 and 10 year corporates are 3.31% and 4.89% the medians are 2.14% and 3.07%. The highest yields are often red flags indicating a possible downgrade. A more realistic expectation is somewhere between the high and median. For this report we will use a 5 year yield of 3% and 10 year of 4%. Is this income enough to commit a significant amount of money for a lengthy period? $100,000 in bonds will provide only $3000-$4000 a year. In addition, inflation could make that $100K worth much less at maturity. This might be satisfactory to some people, but not many.

Bond Ladders: There is one variation that could generate more income and provide some inflation protection. A bond ladder is a portfolio of staggered maturities. Each time bonds at the short end of the portfolio mature they are reinvested at the long end, and the higher yield of longer duration bonds provides a bump in income. To illustrate, I constructed a ladder on fidelity.com of 5 bonds with maturities of 2, 4, 6, 8, and 10 years. The average coupon rate is a respectable 4.37%. At $3930/year the income is at the high end of the range and should increase every two years as the shorter duration bonds are replaced with longer duration.

Bond ladder:

Bond ladder summary calculations:

Principal Cost$98,155.91

Total Par Value$91,000.00

Average Yield 2.37%

Accrued Interest$498.51

Average Coupon Rate 4.32%

Average Price $107.84

Principal Gain/Loss($7,155.91)

Average Maturity (Years) 5.97

Annual Interest$3,929.75

Alert readers will see a problem. The cost is $98,156 and the par value is $91,000. The bonds will cash out at $7,000 less than the purchase price because they are offered above par. The price of these $100 par bonds ranges between $104.87 and $115.73. In essence the investor is paying him/herself from the principal, especially in the early years. Some people may decide this arrangement still meets their needs, but most will not. A ladder of bonds purchased closer to par can be constructed, but there will be a corresponding loss of income.

Conclusions

Safe, reliable income is at the top of the list for many if not most retirees. Bonds have always been near the top of the list to accomplish that goal. This is largely what distinguishes them from other investment types. I undertook this study to see if I could get that safety with adequate compensation. Sadly the answer so far is no. I could buy speculative bonds that yield 10% or more, but that undercuts my reason for buying them. When I want to go higher on the risk spectrum the choices are countless and not limited to bonds.

What can an investor do today with money that needs to be safe and secure? For some, high quality bonds will still be the answer. There may be other bond types, like international, leveraged funds and baby bonds, that should be considered. Some people are biding their time with cash or CDs to see how the economy plays out. Dividend growth investors are happy to own solid stocks like Realty Income (NYSE:O) and Johnson & Johnson (NYSE:JNJ). Others will go for much higher yielding investments, not caring about or understanding the meaning of investment grade vs. speculative.

Behind the common goal of making money there are a countless number of approaches to investment. For many retirees safety and security have outsized importance and we need to be aware of the choices in an ever-changing landscape. Interest rates seem stuck on "low" for the indefinite future, but people old enough to be retired know this will change. When it does, bonds will once again take a more prominent place in the financial plan.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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