Once a decision has been made regarding the planning horizon and other assumptions, the “Details” link at the bottom of the page will list the particular set of bonds to purchase. Table 8.5 provides a list of bonds for the Browns’ 5-year example. This is a set of “precision- guided” bonds that will provide the exact income stream needed.
This sounds like the sort of bond ladder that is old hat among bro- kers, but bond ladders are not precision guided. Because these bonds are designed to bridge the volatility of stocks in the growth portion of the portfolio, bond bridgemight be a more apt descrip- tion. Most brokers continue to blindly follow the old XYZ formula and allocate Y percent of a portfolio to bonds. They may spread out the maturities, but they have no particular reason in mind when they do so. They may simply use bond funds. Even worse, they may suggest trading bonds based on their precognitive powers (or,
“research”) concerning future movements in bond prices. All of this plays havoc with the whole reason why bonds were invented in the first place, of course, and loses the primary advantage that they offer. One of the primary advantages of the asset dedication approach is that it uses each financial instrument for the purpose it was designed to serve.
The Details screen not only identifies a list of bonds in the cor- rect quantities that will provide the income, but also illustrates how they meet the target income stream. Each column in Table 8.5 is described in greater detail in the following section.
Year:The year whose income will be supported by the bond listed
Rating:The rating for the bond. U.S. Treasuries and strips are one step higher than anything else, so the bond rating services (Moody’s and Standard & Poor’s) do not rate them. If they did, they would get AAA+. Sometimes, the simple desig- nation “Gov” is used. Corporate and municipal bonds do have safety ratings awarded by bond rating services. Only double- or triple-A-rated bonds are listed on the web site because only the safest investments are eligible.
CUSIP:The identification number of the bond.
Name:The name of the bond followed by a brief description.
Matures:The date on which the bond matures.
Building an Asset Dedicated Portfolio: Doing It Yourself on the Internet 171
Table 8.5 Details Screen: Bonds for the Income Portion of the Browns’ 5-Year Plan YearRatingCUSIPNameMaturesCouponYTMPriceQuantityPrincipalInterestTotal 2004Aaa/AAA31359MEM1Federal Natl Mtg Assn2/13/20045.1250.757$101.8236$36,000$10,581$46,581 2005Aaa/AAA3133M3KB0Federal Home Ln Bks2/18/20055.821.519$106.0739$39,000$8,736$47,736 2006Aaa/AAA31359CCD5Federal Natl Mtg Assn2/2/20065.8752.281$108.3144$44,000$6,466$50,466 2007Aaa/NR31331Q3M7Federal Farm Cr Bks Cons Systemwide Bds1/16/20071.8752.657$97.5148$48,000$3,881$51,881 2008Aaa/AAA3133M2M20Federal Home Ln Bks1/22/20085.8453.524$109.3051$51,000$2,981$53,981 Total$228,230$218,000$32,644$250,644 Security prices listed are estimates only—actual prices may vary at time of purchase. Also, these particular securities may not be available at any given time depending on market conditions. Other bonds with similar maturities, coupons, and yield to maturity (YTM) may be subsituted for those shown. Contact Asset Dedication for assistance if needed.
Coupon: The annual interest rate that the bond pays, usu- ally semiannually.
YTM:The yield to maturity based on the price shown.
Price:The price on the date the information was downloaded to the web site. These prices vary depending on the source of the bond, prevailing interest rates, and continual fluctua- tions in the market, similar to the fluctuations in the prices of stocks.
Quantity:How many of each bond to purchase. (Bonds must be purchased in $1000 or $5000 units; some brokers require minimum quantities of $10,000 or $25,000.)
Principal:Cash inflows resulting from redemption of the bonds
Interest:Cash inflows resulting from interest payments from bonds that have not yet matured.
Total:Principal plus interest.
Target:The original specified target income stream over the horizon.
Table 8.6 summarizes the resulting income stream from these bonds and compares it to the target income stream. As can be seen, the results are remarkably close. Based on the Rsquared measure, the correlation between the target income stream and the actual income stream is 99.42 percent. Over the 5-year period, the cumu- lative difference amounts to $540, or 22 basis points (0.0022).
Building an Asset Dedicated Portfolio: Doing It Yourself on the Internet 173
Table 8.6
Comparison of Target versus Total Actual Income Stream
Total Total Absolute
Target Actual Minus Absolute As Value as Income Income Target Value Percent Percent
$46,176 $46,581 $405 $405 0.87% 0.87%
$48,023 $47,736 ($287) $287 −0.60% 0.60%
$49,944 $50,466 $522 $522 1.03% 1.03%
$51,942 $51,881 ($61) $61 −0.12% 0.12%
$54,019 $53,981 ($38) $38 −0.07% 0.07%
$250,104 $250,644 $540 $1,313 0.22% 0.54%
Per year: $108 $263
RSquared 99.42%
The Browns may wish to purchase a different set of bonds, which is perfectly acceptable so long as the bonds have the same characteristics as these do in terms of coupon, yield, price, and rat- ing. In fact, it is unlikely that the particular set of bonds shown on the web site will be available at the moment the Browns decide to proceed. Bond inventories are finite. U.S. government bonds (Trea- suries and agencies) are usually available at all times, but corpo- rate and muni bonds may not be. Once they are sold, they are no longer available unless someone who owns them puts them up for sale. Substituting equivalent bonds for those shown should present no problem. The more similar they are to those listed, the closer the results will be to the total dollar figures shown. Minor deviations in the bond characteristics should produce only insignificant differ- ences in results.
CONCLUSION
Once they are comfortable with their plan and have tested as many scenarios as they wish, the Browns can then implement that plan.
They have done their homework and set their plan in motion. If they follow the passive approach and use index funds, they can for- get about trying to time the market or attempting to be clairvoyant in selecting the next hot stock. The volatility of the market will no longer matter to them. They can turn to other activities, knowing that their portfolio will now provide for their needs, much like a ship entering a safe harbor. Their accumulated assets have been dedicated to the purpose for which they were designed.
NOTES
1. It is called the Trinity study after the three authors, who were professors at Trinity University in San Antonio, Texas. Software that utilizes their methodology is now available from Zunna Corporation (www.zunna.com).
2. If the base period begins in 1926 instead of 1947, the corresponding probabilities are within 1 or 2 percent of these probabilities, which are updated with each passing year. The point is they have about a 60 to 65 percent chance of achieving this return.
3. Theoretically, the 50 percent probability would apply to the median rather than the mean.
4. In Excel, the IRR(…) worksheet function performs this calculation.