Friday, February 19, 2010

Store Money in Your Pantry, Grow It in Your Fields

Our last post referenced an industry article which talked about a new way to build bond ladders outside of the Functional Asset Allocation™ method of using Treasury STRIPs, and this follow up addresses the danger of chasing return in fixed income vehicles.

(For a quick refresher on the simple genius of FAA and how the interest earning 'Pantry' combines with the 'Farm' real estate and 'Crops in the Field' equities to produce the best real life asset allocation model, read our newsletter Cents & Sensibility #19.)

We must be very careful in introducing credit risk to a bond ladder. The 'bond bridge' strategy described in the article takes a reasonable approach as using Treasuries, TIPS and FDIC insured CD's to build a ladder guarantees that those vehicles mature to their stated amounts on their stated maturity dates, backed by the ability of the U.S. government to print money. However, using other vehicles like municipal or corporate bonds, even if high grade, means that the return of that capital cannot be guaranteed. The only true guarantee we have of return of principal is from an entity that can print money.

This may not seem like a big deal when so many large companies seem like they have a license to print money and the excess return their bonds might provide is attractive. But remember that one unchanging fundamental of investing is that there is no extra return without taking on some kind of extra risk - none. And when we plan to have a specific amount of retirement income available at a specific time, that extra risk, however small, is unacceptable.

Imagine being retired in the fall of 2008 and counting on your income for 2009 to come from a bond ladder containing Fannie Mae, Freddie Mac and Lehman/Goldman/AIG bonds. Five years earlier when building that ladder, those bonds looked as blue-chip as they come, and paid an interest rate that was more attractive than Treasuries.

As it turned out, holders of those bonds came out OK because of the bailout. But how much peace of mind would you have had knowing that failure of one or more of those institutions meant that you either had to: 1) sell stocks in the middle of one of the worst market crashes in history which could cripple your financial future or 2) go back to work to make ends meet. How well would you have slept at night?

Our last newsletter #27 highlighted the huge deficits some states are facing, and you can bet that many municipalities are in the same boat. If you were building a bond ladder 10 years ago (when the economy had been surging along for 7 years running) to provide reliable income for retirement, who would have guessed that Fannie, Freddie and Lehman would go bankrupt and that more than half of states would be swimming in red ink within the decade?

Remember that the purpose of the fixed income Pantry is storage, return OF capital not return ON capital. Focus your efforts for growth in the equities in your Fields. And as Bert Whitehead says in the Investment News article, remember that in fixed income safety trumps yield.

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