Bonding With Bonds

Sanjib Saha

FOR MANY YEARS, I didn’t own bonds or anything similar, except some bank certificates of deposit. Frankly, I was clueless.

My first dilemma: Should I invest in bonds if I have a mortgage? It didn’t make sense to me to borrow from the bank and, at the same time, lend out my money at a lower interest rate to a bond issuer. I felt I should pay off my mortgage first. A few friends and even a financial advisor recommended otherwise. Their objections notwithstanding, I followed my intuition. I was relieved to find out later that my view wasn’t so naïve after all.

Fast forward a few years and I had the mortgage paid off. A magical side effect: My entire paycheck no longer disappeared. For the first time in my career, I realized I could take a long break from work if I had to. This feeling of freedom planted the idea of early retirement in my head. I probed my financial readiness and realized that bonds would now play a vital role.

For the next few months, I researched bonds, including different kinds, the risks, credit ratings, taxation, liquidity and so on. Alas, I was left with more questions than answers. What percentage should I allocate to bonds? Individual bonds or bond funds? Is credit risk real? Should I worry about duration or convexity? What about inflation? Tax-exempt or taxable? Government or corporate?

Overwhelmed and confused, I needed a simpler approach, so I started over, but this time with a basic question in mind: What are the big problems with my retirement finances and can bonds solve them? This gave me much needed clarity.

My financial situation posed two challenges. First, my modest nest egg needed a high stock allocation to survive a longer-than-average retirement, and yet I also needed bonds to diversify. Second, being more than a decade from tapping Social Security, I needed to withdraw large amounts in my initial retirement years. On top of this, I couldn’t even touch my retirement accounts for another few years. True, my frugality was an advantage. Still, I needed a secure and predictable cash flow to cover at least the bare minimum expenses until other income sources were available.

To simplify construction and maintenance of my portfolio, I set a few guidelines. The bond portion of my portfolio would include only high-grade issues with little default risk. I treated CDs and cash equivalents as part of my bond allocation. I didn’t worry about inflation, because my overall portfolio had other components to handle it. Chasing yield—especially at the expense of credit quality or liquidity—wasn’t a goal.

My first goal—a better balance between stocks and bonds—was easy to address. I needed a high-quality, liquid bond fund to add to my long-term investment portfolio and complement my stocks. There were plenty of low-cost core bond funds to choose from. Some owned only Treasurys and some had a mix of government and top-rated nongovernment issues. I narrowed my choice to intermediate-term funds, since they offered a good tradeoff between yield and vulnerability to rising interest rates, which would drive bond prices lower. Meanwhile, the liquidity of a fund, coupled with the freedom to make commission-free transactions, would allow me to rebalance my stock allocation as needed.

With my long-term investment portfolio straightened out, it was time to deal with my second goal: predictable cash flow for the next decade or so. This was trickier to achieve. Given my nest egg’s size, the best I could do was use bonds and bond-like investments to cover all expenses for the next year or so, cover essential expenses for a few years beyond that, and only the bare minimum—things like taxes, insurance, property upkeep and so on—for the remaining time. I would then look to replenish this part of my portfolio by occasionally selling stocks from my long-term investment portfolio.

What if stocks performed poorly year after year? With the amount I’d allocated to the core bond fund held within my long-term investment portfolio, I felt I would still be able to hang tough without losing sleep over making ends meet. The alternative was to forget financial independence for now and focus on saving more. I chose financial independence.

The short-term cash reserve to cover upcoming spending was taken care of through online high-yield bank money-market accounts, plus individual Treasury notes and bills. My brokerage firm had a convenient tool to buy Treasurys at auction and then roll the proceeds from maturing issues into new issues. The money-market account plus Treasurys provided more yield than simply owning a money-market fund or a short-term Treasury fund.

For my mid- and long-term cash flow, I set up a ladder of investments maturing every year up to the year I’d start Social Security. With a ladder, I didn’t have to worry about interest rates rising or figuring out the best time to sell. Instead, I needed to focus only on credit quality and earning a reasonable yield.

Target-maturity bond funds looked promising. They offered both issuer diversification and timely return of principal. But I wanted better credit quality. I decided to go for individual noncallable bonds from financially strong companies. I stuck to only the upper-half of the investment grade spectrum. It was tedious and time-consuming to pick each issue, but it was worth the effort. Overall, I ended up with a well-diversified portfolio that included one large bond fund for rebalancing, several individual Treasurys, some high-grade corporate bonds, some long-maturity bank CDs—and greater confidence about my early retirement.

A software engineer by profession, Sanjib Saha is transitioning to early retirement. His previous articles include Measuring UpIt’ll Cost You and Mind the Trap. Self-taught in investments, Sanjib passed the Series 65 licensing exam as a non-industry candidate. He’s passionate about raising financial literacy and enjoys helping others with their finances.

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