Knowledge Base/Product Guide - How To Do

Bond Ladder / TIPS Ladder - A Source of Certain Cash Flow

Income Discovery
posted this on January 08, 2013 02:11

An individual bond is the best match to fulfill the need of a certain cash flow to support the retiree’s expenses during retirement. When held to maturity, a high quality individual bond provides a certain coupon and principal redemption schedule. A ladder of bonds can be structured to provide any desired cash flow stream for the retirement distribution phase.

What is a ladder and how does it work?
Suppose your client wishes to generate $30,000 of cash flow for the next five years. You could use the client’s funds to purchase for them five US government treasuries that would be set up so that one matures in each of the future years. This structure of a bond maturing each future year is called metaphorically a ladder.

During the first year of the ladder, a coupon will be received from all five bonds. Then, one of bonds matures, providing principal redemption cash flow. During the second year, four remaining bonds will provide coupon payments. Another bond matures at the end of the second year and will then also provide principal redemption cash flow.  This same process carries over through the remaining years, until the last bond matures in the fifth year.  During the fifth year, only one bond provides the cash flow.

It is possible to find a number of bonds to buy for each maturity, so that the collective cash flow from the coupon and maturing principal matches approximately the desired cash flow of the $30,000 in our example. The Income Discovery software tool finds the number of bonds for a desired cash flow stream. Such a ladder can also be built using Certificates of Deposit (CDs) issued by banks as well. Following schematic explains it for a 3 year ladder. 

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Since the retiree’s expenses generally increase with inflation during retirement, they need a cash flow stream that adjusts to inflation. The adjustment to inflation needed is not a fixed 3% or 4% increase, rather a perfect adjustment to inflation. A ladder with conventional bonds can provide a fixed increase, but not a perfect adjustment to inflation. The US Government issues securities called Treasury Inflation Protected Securities, or TIPS for short, that provide adjustments based on the CPI-U inflation index.

Here's how TIPS roughly works: the principal of the bond adjusts to inflation and the coupon payments are made on the adjusted principal. For example, if the principal was $1000 on the date of issue and during the first year inflation was 4%, at the end of the first year, the adjusted principal would be $1040. Future coupon payments will be made on this adjusted principal. The principal will keep on moving up with inflation in future years and so will future coupon payments. Using a ladder of TIPS, a cash flow stream with a fixed purchasing power, such as the $30,000 of the previous example, can be built.

Another key aspect to understand is that individual bonds held to maturity are different from bond funds. Suppose the client used a bond fund to generate a $30,000 withdrawal for each of the next 5 years. Every year, the client would sell a few units of the fund holding to fill the gap between the desired cash flow and the coupon payments that the fund distributed. The number of units to sell are determined based on the per unit value of the fund, which in turn depends on the movement of interest rates between today and the day the units are sold. If future interest rates increase, the value of each unit of the fund will reduce, as bond prices fall with upward movement in interest rates. Therefore, the strategy of using the bond fund is quite sensitive to future changes in interest rates and as such can't guarantee any certainty of the cash flow.

Compare that to the strategy of individual bonds held to maturity, where the desired cash flow is frozen on the date the ladder is built. This type of cash flow stream is NOT sensitive to the future movement of interest rates. The bonds may fall in price if interest rates move up, however the client is not going to sell them.  Therefore, the price movement is of no significance for the client who chooses to hold the bonds to maturity.

Imagine the peace-of-mind a bond ladder can give the client – a one-time purchase leading to desired cash flows without any further action. 

 
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