A.I.M. Users Bulletin Board

[ls7550]

3% real (synthetic) inflation bond recipe

All in TIPS/inflation bonds is a high concentration risk. Best never to be all-in on anything. With a current era of negative real yields even on 'safe' inflation bonds I thought I'd share this Easter recipe (in the UK our fiscal years still align with the Catholic calendar years so we're more inclined to rebalance at end of March/early April years so we can opt to make changes in the old or new year (or a combination of both) according to whatever might be the more tax efficient).

Ingredients :

World stock tracker fund
Gold tracker fund
Treasury bonds

Preparation :

Divide the total $ amount being invested by three and drop one third into stocks, one third into gold.

With the remainder put 3% of the total portfolio amount aside as your first years income (cheque/check account), that's a perpetual inflation adjusted withdrawal amount i.e. at the start of the 2nd year you adjust that $ amount by inflation as the amount drawn from the portfolio for the second years income, and so on. That's commonly called a SWR (safe withdrawal rate) and is a nice inflation pacing amount (consistent).

With the rest (30% of total amount) divide that by 10 and buy 1, 2, 3 .... 10 year treasury bills/notes/bonds in equal $ amounts. i.e. a simple 10 year ladder.

Cook : for a year i.e. until a bond matures, that's the time to 'rebalance' the portfolio. Rebalancing involves putting 3% of the then total portfolio value into another 10 year Treasury bond purchase, draw your SWR amount and sell/buy holdings to bring all three of stocks/gold/bonds back close to a third each capital values. That may involve adding to or reducing treasury bond holdings, when so just use discretion as to which ladder rungs are drawn-from/added-to. If the differences in weightings are relatively small its perfectly acceptable to not bother making any portfolio changes. Primarily you're looking to not have too much in any one asset as concentration risk is a major risk.

Rinse and repeat.

Reasoning/Concept :

A 50/50 barbell of Stock and gold are two polar opposites. One (stocks) will tend to do well during prosperity when real yields are positive, the other tends to do well when stocks falter and real yields are negative. Combined they form the equivalent of a currency unhedged global bond, similar to how a barbell of 1 and 20 year treasury bonds combine to form a central 10 year bond bullet. When that is combined weighted 66% and supplemented with 33% cash the overall portfolio gain progression is inclined to be relatively linear and upward sloping over time. Example here

Primarily for retirees. When your young and still adding savings then declines are buying opportunities that help cost average down the average cost of stock. When you're retired and drawing income you don't want for instance a decade long period of negative total real (after inflation) returns (with dividends/interest reinvested) when you're also drawing income from that portfolio as the two combined can pull down the portfolio value to critical/fatal levels. Check out this link for example and click the inflation adjusted tickbox in the chart. That shows a 3% SWR rate applied to the above and compared to all-stock. After just a couple of years the all-stock portfolio had lost more than half its inflation adjusted value.

Here's yet another more recent example for 2000 to 2009 where at the end of Feb 2009 just 32% of the inflation adjusted 2000 start date portfolio value remained.

Yes over other periods when stocks do well, it will lag, but still provide OK rewards, meet its 3% inflation bond type objective.

Beneath the seemingly simple concept of diversifying equally across stocks, commodity and bonds and holding some foreign currency (gold is also a form of global currency), there's some interesting characteristics. You're in effect using 3% of the current portfolio value to buy some income in 10 years time. If the portfolio had done well then the 10 year income being bought would be a higher amount than if the portfolio had performed poorly. More often after a portfolio has endured a bad decade, either the preceding or subsequent decade tends to do relatively well. So whilst a maturing bond after 10 years that was relatively lightly loaded due to poor portfolio performance a decade earlier may fall short on providing the SWR type withdrawal, likely portfolio gains since will be inclined to have been good. Similarly if a maturing bond was relatively heavily weighted i.e the portfolio had done well when that bond was purchased a decade earlier, then the current portfolio value may be relatively poor (bad decade), but where there may be sufficient capital arising from the maturing bond to cover the SWR. A form of time-shifting to average out performance and overlap good/bad times to yield more 'average' result.

I'd go as far as suggesting that is actually safer that TIPS due to not having high single asset concentration. If for instance TIPS were withdrawn, or taxation policies changed adversely, 10% inflation, 10% TIPS yield, 40% taxation = -4% real net outcome, perhaps compounded over a number of years. And at present negative inflation bond yields in many cases, more rewarding also.

With recent good stock gains, now might also be a appropriate time to consider taking some off the table. Buffett for instance who typically AIM's with 10% cash reserves, is more recently aligned to more like 30% reserves.

Happy Easter and merry cooking.

Clive.