Barry Bonds

This post is kind of a follow-up to my book review of The Four Pillars of Investing. In that post I was left mulling over the idea of getting a TIPS (Treasury Inflation-Protected Security) ladder for a Liability Matching Portfolio (LMP), replacing my current strategy of maintaining and spending down a diversified portfolio of stock and bond funds.

To briefly recap: the appeal of a TIPS ladder is that it completely eliminates the uncertainty in retirement planning. You are buying a rock-solid guarantee to receive certain payments, adjusted for inflation. Our goal in retirement planning isn't to die with the most money, it's to ensure that our needs are provided for. A phrase Bernstein has that I like is "When you've won the game, it's okay to stop playing." So over the course of our working life we can build up our nest egg by riding the volatile up-and-down of stocks. Once we reach a point where we can purchase that guaranteed real income for life, we can do it, and not worry about sequence of returns risk or runaway inflation or any of the many other concerns we might have.

I have a few hesitations. First is just changing my strategy at all; as Bernstein also says, sticking to a sub-optimal strategy often has better results than chasing superior strategies.

On a technical level, one issue I've been grappling with is where, exactly, I would hold my TIPS. I think Bernstein's assumption is that you would have it in a traditional IRA at a discount brokerage. In this setup you can purchase arbitrary holdings, including specific government-issued bonds, and don't need to worry about taxes until you withdraw the funds for spending.

That isn't really an option for me, though. The bulk of my tax-deferred retirement savings are in a 401(k); my particular plan has great options, but it isn't a brokerage, so I can't buy specific bonds in it. I do have a Roth IRA, but it isn't large enough to hold the ladder I want; also, I believe the conventional wisdom is that it's best to hold high-growth investments like stocks in a Roth since you won't be taxed on any appreciation. And I don't want to start contributing to a new traditional IRA, because that would make future Roth conversions a lot more painful.

One possibility would be to wait until I retire or leave my job (which may not be any time soon - more on that below!), roll my 401k into a traditional IRA, and proceed from there, and I suspect that's what most of Bernstein's clients would do. But who knows when that would be, and at that point I think I'd be effectively boxed out of any future contributions to a Roth. Not a bad thing if I'm actually retired, but I think it's more likely I'd pick up another job in the future, and I'd like to keep the Roth door open.

By default, that leaves purchasing the ladder in a taxable account. All of the early guidance I've read has strongly warned against that, for the simple reason that you have to pay regular income tax (not capital gains tax) on all the interest generated by your ladder. TIPS also have what is called "phantom income": the principal amount is adjusted for inflation each year, and you need to pay tax on that adjustment, even though you don't access the money until maturity.

While doing this research, though, I found that "I bonds" can make a lot more sense in a taxable account, so that became my first step. "I bonds" are more like a traditional EE savings bond: you buy them directly from the Treasury, not a brokerage, you can hold them until maturity or sell early, and redeem with the government. Like TIPS, though, Series I bonds are adjusted for inflation, so buying $1000 in I bonds today will give you back an inflation-adjusted equivalent to $1000 in 2054 dollars when they mature, in addition to the fixed rate of interest they generate.

This is a good time for buying I bonds. Like most products, they paid essentially 0% interest for the last decade-plus; now, there's some positive interest, in addition to the inflation adjustment. The main downside is that you have to buy them from the Treasury Direct website; I didn't find this quite as painful as its online reputation suggests, but it definitely feels like a circa-2003 website. The other downside is the limited purchase amount: each person can only buy $10,000 in I bonds each year. (Though people with trusts or access to other legal entities can legally purchase more.) They do seem great, though, and I'm happy to be on this train now. There's really no downside: total inflation protection, no volatility, and very flexible redemption terms: you can redeem after 1 year, have to forego 6 months' worth of interest if you redeem before 5 years, and otherwise can hold for as long as 30 years.

So I bonds look great, but by themselves can't build a ladder, since you can only buy so many in a given year. My current tentative thinking is that I'll use these to fund additional spending after I start collecting Social Security. I'll likely try to delay claiming until age 70 (assuming rules remain the same) to maximize my benefit. Some back-of-the-napkin math suggests that, if I don't have to pay for housing, my Social Security benefit should cover most of what I'd need, and I bonds should cover the rest. So I'll continue buying those in the coming years, so long as there's a fixed interest rate of above 0%. I should have some "extra" from this, which I could maintain as an emergency fund or redeem before 30 years to help fill a pre-age-70 retirement ladder rung.

Which brings us back to TIPS. After several more months of researching, hemming and hawing, I've come to the tentative conclusion that holding them in a taxable account isn't the worst thing. One big reason for me in particular is that I live in California, which has a relatively high state income tax rate, and TIPS like other federal government bonds are exempt from state (not federal) taxes. So I think I'd relatively benefit more from TIPS in taxable than someone who lived in a lower-tax state.

I'm also already holding bond mutual funds in my taxable account - that's kind of a separate post, I've been trying to shift that over to my 401(k) but it's complicated. But anyways, the taxes you pay on an individual bond are basically identical to what you pay for a bond fund, even something like "phantom income". Over the long run, I'll be counting my TIPS, I bonds and Total Bond Market funds in the same bond "bucket" (when tracking asset allocation and directing future investments), so the bond funds will be shrinking (at least as a percentage of my portfolio) while keeping overall bond exposure the same.

So, at a high level, over the next, I dunno, maybe 10 years or so I'm imagining shifting from bond mutual funds into individual bonds making up a ladder.

I originally pictured this process as pulling a huge trigger, selling a gut-clenching number of stocks and buying a heart-pounding number of TIPS. And it seems like quite a few people do that. My main hesitation for doing that is uncertainty. There's a really good chance I will work for another twenty years, maybe even longer, and with that kind of horizon there's really no reason to not be in stocks: even if we had another 1929, 1987 or 2008 I'd be better off riding the wave. And I'm not completely sure yet what my living situation will look like: I'll very likely be in California, hopefully in the Bay Area, but housing has been by far my biggest expense for most of my life, and will have a huge impact on how much money I have available to purchase a ladder as well as how much money I need to get from that ladder.

Even though I was originally planning to get to a binary Yes/No decision, I've ended up with more of a gradual glide path, which is a little surprising but honestly feels pretty good. My current plan is that, rather than buying a ladder on the secondary market, I'll start buying rungs directly from Treasury auctions, likely with new issues of 10-year TIPS. I can keep this up for several years as my financial picture solidifies. There's a decent chance that the early rungs will mature before I retire, and that's okay! It means that particular rung will be a rolling ladder instead of a consumption ladder.

There are two big risks to this approach. One is that interest rates are slashed again and real yields go back to 0%. The other is that there is a big stock market crash and I have fewer assets available to buy bonds. That's the big argument for plowing ahead now rather than slow-rolling it. Still, as noted above, my time horizon is long even if I don't yet know the precise number of years. Even if both of those things happen, eventually rates will come back up and eventually the market will recover, and by the time that happens I'll be closer to retirement and have a clearer picture of what I need.

So, those were two big firsts for me this year: my first time purchasing a Series I bond on treasurydirect.gov, and my first time buying a Treasury security at auction. There are plenty of online articles and guides walking through how to do both of those things, so I won't recap them here. I bought the 2034 TIPS reissue via my brokerage; I'll probably try to do original issues for future years but from what I've read it doesn't really matter much. I'll definitely stick with the brokerage for buying future TIPS though, from what I've read buying actual treasuries (not savings bonds) at Treasury Direct is a nightmare.

One thing I haven't done yet, but might in the future, is buy TIPS on the secondary market. That's how most ladder purchases go, buying previous issues at a discount or premium to fill all your rungs. It sounds like you can only do that during a trading day, making actual bids on the market, which sounds kind of exciting - I can see why people get hooked on day trading! I am kind of toying with the idea that, going forward, I'll buy a new 10-year TIPS at auction and a 20-year TIPS on the secondary: for example, in 2025 buying a new issue that matures in 2035 as well as a 30-year issue from 2015 that will mature in 2045. I do like the gradual approach that implies, but haven't committed to doing it yet.

If this is at all interesting to you, you may also like a recent video Rob Berger put out on TIPS ladders. I discovered his channel a few months ago and have been enjoying it - he has a pretty Boglehead outlook, a very calm and pleasant demeanor, and is good at talking about complex topics in a simple way. Many of his videos are about things I'm not interested in, which is fine, I just skip those; when other ones like this TIPS video appear, they're great for me to validate my understanding or learn something new. He does close with a good point that this doesn't have to be all-or-nothing, you could use a TIPS ladder to create a "spending floor" for, say, half of your expected expenditures, and plan to fund the rest from a 60/40 or 70/30 portfolio. My immediate response to that was "Meh" - the whole point of a TIPS ladder seems to be eliminating uncertainty, so why only half-commit? But I think that's good advice for people like me who may otherwise be frozen in inaction due to uncertainty.

Uh, I think that's it for now! This post is probably the best evidence to date that I am getting Old, I never would have thought I could get this excited about bonds.