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Research Articles

Bond Ladders & Income Annuities: Restoring the Sanctity of Fixed Income

The following is an abstract. Here is a link to the full article: Bond Ladders & Income Annuities

In a nutshell: Income annuities and bond ladders are fixed income investments, but I find they are under-utilized as tools for financial planning (especially with respect to retirement income).

I spent some time on Google, but could not ascertain the origins of the term fixed income. Presumably, it was just a simple description given to investments where all of the related cash flows were dictated per contractual obligation. For example, this could be something as simple as a government bond that pays fixed coupons and returns the principal at maturity. However, the term fixed income has now come to describe pretty much any investment obligated to pay a prespecified stream of cash flows – some of which comprise both interest and principal (e.g., mortgage-backed securities).

Brushing some details under the rug (e.g., some bonds can be called), fixed income investments effectively allow investors to purchase future cash flows with a high degree of certainty. However, it is important to note this degree of certainty only applies when the investments are held to maturity.

If an investment is sold before it matures, the sales proceeds will naturally be at the mercy of the market. Other investors will take into account the rest of the cash flows to be paid and discount them via relevant interest rates. Thus, in the case where fixed income investments are not held to maturity, much of the certainty can be lost.

Without doubt, the high turnover found in many bond funds will naturally destroy this essence of fixed income. Moreover, advocates of total return investing who take portfolio income and put it right back into the market also seem to disregard the inherent stability of contractual cash flows.

This article attempts to restore this sanctity of fixed income. In particular, I advocate for the design and utilization of fixed cash flows in the context of asset-liability management (ALM) – thereby mitigating, if not avoiding, market volatility. While relevant to other investment mandates (e.g., private foundations with cash flow liabilities), I discuss this notion in the context of retirement income.

I use bond ladders and income annuities to highlight some potential benefits of this approach. In addition to potential cost and tax savings, the math behind this approach (i.e., time value of money) is much simpler than many of the statistical models used for portfolio management. Accordingly, I believe this approach can facilitate greater understanding and peace of mind for many investors. Retirement income is one natural application for this strategy. However, it can also be helpful in estate planning for blended families and other situations where one wishes to manage multiple beneficiaries’ claims to income and principal.

Note: Readers interested in this topic may also like to read an earlier article I wrote (Destroying Stable Income Streams) that focuses on a similar topic, but primarily in the context of dividends.