Fixed Income Construction

I saw something somewhere early yesterday before heading down to Phoenix that the Treasury is going to be issuing a greater percentage of TIPS for its borrowing needs. Apologies, I do not have a link so I am not sure when this will start but it is not crucial for this post.

Inflation protected securities, accessed one way or another, have a lot of utility because inflation is the biggest threat to regular bonds (and notes to a lesser extent). The biggest downside to TIPS is that the yield is lower than on conventional paper.

If we are indeed headed toward higher price inflation than we have been used to for last decade or two then having more TIPS exposure certainly is compelling. This may however leave a hole in the income stream of people living off their investments. If regular treasuries become less compelling in favor of TIPS then this would seem to imply that there must be a higher yield generated in the rest of the bond portfolio.

I don't think that is the best way to look at it. A better way, if you don't already do this, is to view the income stream as coming from the entire portfolio which includes interest, dividends and the occasional (or frequent) trade that gets done. Someone with a $1 million portfolio pulling out $40,000 per year (4% withdrawal rate) won't have to do that much work to create the income stream. With a 65/35 mix assuming an average 3% yield on the fixed income and a 2% dividend yield on the equities is more than halfway home with $23,500 right there. If we assume zero price appreciation from the fixed income then the remaining $16,500 needed to get to $40,000 has to come from equity price appreciation. Doing the math the person needs to only average 2.5% price appreciation to work out shorter term.

Longer term you would need to average more than that to account for inflation.

In getting to that 3% yield which sounds a little high these days unless you go way out in maturity which is a bad idea IMO, you would need to be a little innovative. If $350,000 is targeted for fixed income then the interest hoped for would be $10,500. Putting 5% into a couple of different higher yielding closed end funds might bring in $1575 per year (assumes a 9% yield which is realistic for the type of fund I mean). That means the other $332,500 has to produce $8925 or 2.68%

Another 15% could be put into investment grade corporates of intermediate maturity (5-6 years) with yields available in the high 3%. $52,500 with an average yield of 3.8% produces another $1995 leaving $6930 to be generated from the remaining $280,000 so it needs to yield 2.475%. From there some foreign could be added and maybe one or two other things in similarly small doses such that a lot could be allocated to TIPS if need be. The idea being that all of these other things have risk but it does not require owning a lot of the riskier fixed income segments to construct a reasonable fixed income stream.

There has been one reader who says a 4% withdrawal rate is too risky. If you agree then you obviously would need to plan accordingly in terms of savings and portfolio construction. One final point to make is that with yields in general so low these it makes most fixed income products unattractively priced. I see no urgency to implement a full fixed income portfolio right here. The numbers in this post are an example only.