Bond Ladder Using TIPS

A TIPS bond ladder can provide inflation-risk free retirement income.

We will be using TIPS with 30-year maturity to build a bond ladder that generates $10K a year in inflation-adjusted real income for the next 30 years. TIPS and other bond types are described in detail in our blog “Bond Types.” TIPS (Treasury Inflation-Protected Security) is a special kind of bond in which the Face Value is continuously adjusted for inflation and denoted as Accrued Principal. The fixed coupon rate is applied on the Accrued Principal resulting in inflation-adjusted coupon payments (C). This is equivalent to TIPS paying a real coupon rate on the $1000 Face Value (F). TIPS also pays back the Accrued Principal at maturity.

The chart shows the construction of a bond ladder using 30-year TIPS. The desired income is generated from the maturing principal and the coupon payment, which is from all the TIPS maturing in the current and later years.

We made a few simplifying assumptions before starting to build the bond ladder. We picked the first maturing TIPS for each year. However, the Treasury did not issue a 30-year TIPS maturing in 2030-31 and 2033-39. Therefore, we used TIPS maturing in the following years, 2032 and 2040, to fill the gaps. Brokerage and transaction fees are not included. The two semi-annual coupons are combined together for calculation purposes. Fractional TIPS were used for computing cost.

The next chart shows the TIPS quote from WSJ. It includes the maturity date, coupon rate, Bid price for selling, Ask price for buying, YTM (Yield to Maturity and other bond fundamentals are covered in “How A Bond Works”) and Accrued Principal. The Ask/Bid prices are normalized for 100 and needs to be converted to a regular bond price using (Ask price / 100) x Accrued Principal.

The bond ladder needs to be constructed by working backwards starting with the last year (Year #30). The $10K of real income for 2049 will come from the last coupon payment (Coupon Rate x Accrued Principal) and maturing face amount (Accrued Principal) of the 2049 TIPS. We need 9.83 shares of 2049 TIPS to generate the desired income, which will cost $10,101 (Adjusted Ask x number of TIPS).

The 2048 income (Year #29) is sourced from the coupon payments from 2048-49 TIPS and the face amount from 2048 TIPS. In order to calculate the number of 2048 TIPS, we first need to calculate the income contribution from 2048 TIPS, which is the income desired minus coupon payments from other TIPS. We can then apply the same steps as for Year #30 to calculate the number of shares and cost to acquire 2048 TIPS. Finally, this process is repeated for the other years in the bond ladder.

Here is the output of the bond ladder we just constructed. The total cost of setting up the 2020-49 30-year bond ladder to generate $10 a year in inflation-risk free real income is $267K. The bond ladder provides an IRR of 0.78% in real terms. The implied withdrawal rate is 3.75%. It means that an investment in an asset that provides 0.78% in real return will allow you to withdraw 3.75% of the asset every year for 30 years before it is completely depleted.

The TIPS bond ladder has a positive Yield Curve, which means that TIPS with longer maturity provides higher yields.

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