Income Matching Using Bonds NorCal 2011

653 views

Published on

Presentation slides from FPA NorCal 2011. Steve Huxley and I presented on how to create pension-like income usning individual bonds. Also contrasted against annuities, dividends and REITs.

Published in: Economy & Finance, Business
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total views
653
On SlideShare
0
From Embeds
0
Number of Embeds
6
Actions
Shares
0
Downloads
6
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide
  • BBSpeaking the same language tradeoffs in both. Slightly different approach but you can see the paralells
  • BBA lot of you are wondering about how the dedicated portfolio approach would have worked over time. In addition to intuitive for clients, it works. Let us show you some of the empirical research that gets us excited.
  • BB
  • SH
  • Income Matching Using Bonds NorCal 2011

    1. 1. Income Matching Using Individual BondsAn Alternative to Annuities and Bond Funds<br />Presented by:<br />Stephen Huxley, PhD<br />Brent Burns<br />
    2. 2. Risk<br />Things may not always turn out the way you planned<br />© Asset Dedication, LLC 2011<br />
    3. 3. Market Timing<br />Sometimes it’s hard to guess where the market is going.<br />© Asset Dedication, LLC 2011<br />
    4. 4. Hot Stocks<br />Just because Cramer says it’s a good idea doesn’t mean it’s right for you<br />© Asset Dedication, LLC 2011<br />
    5. 5. Risk<br />The worst case scenario seemed a lot less likely a few minutes ago<br />© Asset Dedication, LLC 2011<br />
    6. 6. Stock Picking<br />Much more scientific than chimpanzees throwing darts<br />
    7. 7. Financial Planning<br />It is a lot easier to get where you are going if you have someone to help steer you in the right direction<br />© Asset Dedication, LLC 2011<br />
    8. 8. Uncertainty<br />It turns out that the stock market doesn’t always go up<br />© Asset Dedication, LLC 2011<br />
    9. 9.
    10. 10. Decline in Traditional PensionsFortune 100 Companies 1985-2010<br />
    11. 11. Liability-driven investing (LDI) is an investment strategy of a company or individual based on the cash flows needed to fund future liabilities<br />Source: Wikipedia<br />cash flows<br />future liabilities<br />
    12. 12. Behavioral Finance Meets Asset Allocation<br />
    13. 13. Clients with multiple goals and varying timelines have trouble relating to stocks, bonds and cash are blended into a single portfolio. People tend to use mental accounts to manage various goals in their head. A pure Total Return approach creates a single portfolio that isn’t intuitively linked to the underlying goals.<br />
    14. 14. Client Needs<br />Liquidity for current expenses<br />Predictable near-term cash flows to cover near-term expenses (usually 8-10 years for those in retirement)<br />Long-term growth to ensure sufficient growth to cover future needs<br />
    15. 15. Total Return Asset Allocation<br />Long-Term Growth<br />Cash Flow Needs<br />Bonds<br />Stocks<br />Cash<br />
    16. 16. Splitting assets into multiple sub-portfolios helps clients better understand and stick to an allocation strategy. Bonds are specifically allocated to predictable current or future income (LDI). Equities are dedicated to long term growth, but are given time to ride through bad markets (long-term total return). Each asset class is dedicated to the function it best serves.<br />
    17. 17. Total Portfolio<br />Split into sub-portfolios to serve different purposes<br />Bonds<br />Stocks<br />Total<br />Return<br />Liability Driven Investing<br />
    18. 18. Asset Allocation and Time HorizonUsing Asset Classes That Fit How Clients Think About Their Money<br />Stocks<br />Bonds<br />Cash<br />8 Years – Prefers predictable bonds <br />Today -<br />Prefers liquidity of money market<br />9 Years – Prefers higher return prospects of stocks<br />Next Year – Prefers predictable bonds <br />7 Years – Prefers predictable bonds <br />Time<br />
    19. 19. Parallels Between MPT and DPT <br />Modern Portfolio Theory<br />Dedicated Portfolio Theory<br />Risk-free asset = T-bills<br />Risk-free asset = Fully immunized cash flow stream<br />Return<br />Return<br />Risk<br />Risk<br />
    20. 20. How Often Bonds Beat Stocks<br />S&P 500 and Intermediate Treasury Bond Index 1927-2009 <br />
    21. 21. Worst and Average Spread<br />S&P 500 and Intermediate Treasury Bond Index 1927-2009 <br />
    22. 22. Using Individual Bonds to Build Income-Matching LDI Portfolios<br />
    23. 23. Income-Matching “Paycheck” Portfolios<br />Immediate Income Portfolio – Cash flows begin now<br />Deferred Income Portfolio – Cash flows begin later, when the client retires<br />
    24. 24. Example:<br />$100,000 per year<br />3% inflation adjustment<br />8 year time horizon<br />
    25. 25. Timing Cash Flows<br />Bond quotes 5/12/2011<br />
    26. 26. Cost = $800,220 <br />Duration = 4.3 Years<br />IRR = 2.6%<br />(Fully Immunized)<br />
    27. 27. Immunization Definition<br />“When a bond portfolio is immunized, the investor receives a specific rate of return over a given time period regardless of what happens to interest rates during that time.”<br />Morningstar Bond Course 104<br />
    28. 28. Why Not a Bond Ladder?<br />Bond quotes 5/12/2011<br />
    29. 29. Cost = $800,865 <br />Duration = 4.2 Years<br />IRR = 2.4%<br />Income Shortfall = $15,166<br />
    30. 30. Tale of Two Allocations<br />Total Return<br />LDI<br />
    31. 31. Double Duty From Bonds<br />Standard Benefits<br />Beta exposure to fixed income<br />Diversification<br />Dampen volatility<br />Unique LDI Benefits<br />Predictable cash flows<br />Immunization from rising interest rates<br />8<br />Years of Income<br />
    32. 32. Source: Asset Dedication, 2009. Data set 1927-2008. Indices used for comparison: Equities (both models)—Standard and Poors 500 Index; Total Return Fixed Income Allocation—Barclays Capital US Intermediate Government Index; Asset Dedication Fixed Income—1975-2008 Treasury Bond quotes (source WSJ), 1927-1974 prices backcast against Treasury yield curve.<br />
    33. 33. Monitoring Progress<br />
    34. 34. The Dynamic Dimension -“Flexible” Rolling Horizons<br />Using time to ride out bad markets<br />Taking more off the table when markets have been good<br />Do Not Roll . . .<br />Years<br />
    35. 35. Immediate vs. DeferredIncome Portfolios<br />Immediate Income Portfolio – Cash flows begin now<br />DeferredIncome Portfolio – Cash flows begin later, when the client retires<br />
    36. 36. Deferred Income Portfolio: Leveraging the Yield Curve<br />
    37. 37. Deferred Income Portfolio: Leveraging the Yield Curve<br />$770,911<br />
    38. 38. De-<br />Risk<br />
    39. 39. Interest Rate Risk<br />
    40. 40. Timing Risk<br />
    41. 41. Planning Risks<br />
    42. 42. Behavioral Risks<br />
    43. 43. Why Individual Bonds?<br />
    44. 44. Individual Bonds<br />Vs.<br />Bond Funds <br />
    45. 45. Legal Obligation<br />Vs.<br />Mutual Fund <br />
    46. 46. Decomposing Bond Fund Total Return<br />Income Return<br />Income return represents the sum of portfolio’s coupon payments<br />Income is never negative<br />Price Return<br />Bond prices are inversely related to interest rates<br />Bond prices fall as rates rise<br />
    47. 47. Impact of Interest Rates on Total Return<br />
    48. 48. Impact of Interest Rates on Total Return<br />
    49. 49. 30 Years of Tailwinds<br />Total Return 11.3%<br />Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average<br />
    50. 50. 97%<br />of taxable bond funds were started after 1981<br />
    51. 51. Impact of Interest Rates on Total Return<br />
    52. 52. Impact of Interest Rates on Total Return<br />
    53. 53. Rising Rates 1950-1981<br />Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average<br />
    54. 54. Rising Rates 1950-1981<br />
    55. 55. Rising Rates 1950-1981<br />
    56. 56. Rising Rates 1950-1981<br />
    57. 57.
    58. 58.
    59. 59.
    60. 60. -9.0%<br />S&P 500:<br />10 Yr. Treasury:<br />-5.1%<br />
    61. 61. Catch-22 for Bond Fund Investors<br />
    62. 62. Keep Duration Short and Rates Stay Flat (Japan)<br />
    63. 63. Japanese Interest Rates Since 1985<br />
    64. 64. Historical Interest Rates Average Yield 1800-2010<br />Long Depression <br />Great Depression <br />Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average<br />
    65. 65. Extend Duration and Rates Rise<br />Duration ≈ 5 years<br />Estimated loss ≈ -2%<br />
    66. 66. Headwind of Rising Rates<br />Total Return 2.2%<br />Average Coupon 5.6%<br />Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average<br />
    67. 67. Total Return Shortfall with Withdrawals<br />Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. CRSP 10-year Treasury Index total return<br />
    68. 68. “People have unrealistic expectations of what a portfolio manager can do in a rising-rate environment.” <br />Jim Jessee, president of MFS Fund Distributors Inc. Investment News mutual fund round table in New York on Feb. 9, 2010<br />
    69. 69. Other Income Strategies<br />Annuities<br />Dividend paying stocks<br />Real Estate/REITs<br />
    70. 70. Other Income Strategies<br />Annuities<br />Dividend paying stocks<br />Real Estate/REITs<br />
    71. 71. Based on the Treasury yield curve and standard mortality tables, annuitants can expect to only receive <br />81%-85% <br />of their premium in return.<br />Annuities for an Ageing World, Olivia S. Mitchell and David McCarthy, June 9, 2002<br />
    72. 72. Challenges for Annuities<br />Passing assets on to heirs<br />Managing inflation<br />Flexibility<br />Expenses, commissions, and fees<br />Counterparty risk<br />
    73. 73. Insurance Company Failures California 1991-2008<br />
    74. 74. Other Income Strategies<br />Annuities<br />Dividend paying stocks<br />Real Estate/REITs<br />
    75. 75. Dividend payments from companies in the S&P 500 dropped by…January 2008 to January 2009<br />23.9%<br />Standard and Poors S&P 500 Market Attributes Snapshot<br />January 2009<br />
    76. 76. Other Income Strategies<br />Annuities<br />Dividend paying stocks<br />Real Estate/REITs<br />
    77. 77. 70%<br />of REITs followed by Morningstar cut or suspended their dividends in 2009<br />Morningstar Industry Report 2010<br />
    78. 78. Key Points<br />Individual bonds can immunize against interest rate risk<br />Individual bonds are uniquely suited to delivering predictable income<br />Bond funds will lose value when rates rise<br />Annuities can be expensive and inflexible<br />Dividends and REITs can be unreliable just when your clients need them most<br />
    79. 79. Questions?<br />
    80. 80. Disclosures<br />Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended or undertaken by Asset Dedication) made reference to directly or indirectly by Asset Dedication in their literature or otherwise will be profitable or equal the corresponding indicated performance level(s). Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client or prospective client’s investment portfolio. Historical performance results for investment indices and/or categories generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results.<br />Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Asset Dedication), will be profitable or equal any historical performance level(s).<br />

    ×