Henssler Financial recommends that you follow strict guidelines when purchasing fixed-income securities. Our philosophy, the Ten Year Rule, states that any money you need within 10 years should be invested in fixed-income securities.
The first step in purchasing fixed-income securities is to estimate your liquidity needs for each of the next 10 years. Liquidity needs refer to the difference between your after-tax income and your desired after-tax spending for any given year. You should estimate your future income from all sources, including earned income, pensions, Social Security, income from investments, income from real estate, etc. You should also estimate expected spending, taking inflation into account when making these estimates.
Once liquidity needs are estimated, fixed-income securities (bonds) should be purchased in face amounts that match liquidity needs, maturing on dates that correspond to the dates of the liquidity needs. These bonds should be purchased with the intent of holding until maturity. This is called the “laddered bond” approach, in which you “ladder” each appropriate bond to come due when the funds are needed.
For example, if you estimate that you will earn $40,000 after-tax in 2012, but desire to spend $60,000, you should need $20,000 of principal from your account. In this case, we recommend the purchase of a bond with a face value of $20,000, and a maturity date of either late 2011 or early 2012. This $20,000 should estimate the difference between your after-tax income (including dividends and interest from investments) and your desired after-tax spending for that year. When the bond matures, you are projected to use the proceeds to supplement income in that year to reach your desired spending level. This approach guarantees the bondholder the amount to be received, assuming the creditor makes good on its obligations. This is unlike bond funds, which have no specific maturity dates.
Next, the type of bond to purchase must be determined. Based on your estimated future tax brackets, we recommend either U.S. Treasury securities, CDs or high-grade municipal bonds.
If it is most appropriate for you to purchase U.S. Treasury securities, we will recommend either U.S. Treasury Bonds or Notes if the bonds will be purchased in a taxable account, or U.S. Treasury STRIPs if the bonds will be purchased in a tax-deferred account. STRIPs are zero-coupon bonds that do not pay annual interest, but instead are purchased at a discount to their face value. If you are projected to be in a relatively high tax bracket, we may suggest you purchase municipal bonds from your state of residence, rated AA or AAA. As the purpose of holding bonds is safety, we recommend you avoid all bonds with lower ratings than AA. We also avoid bond funds, other than very short-term bond funds, such as Vanguard Short Term Bond Index (VBISX) as bond funds have no guaranteed maturity value or maturity date.
Initially, we recommend that you purchase bonds that cover your liquidity needs for 10 years. In every subsequent year, you should cover another year of liquidity. For example, in 2011, you should consider covering your 2021 estimated liquidity needs. However, if the stock market’s performance is poor, you always have the flexibility to wait a few months, or even a few years, to continue covering liquidity needs. This is why the Ten Year Rule works—in most cases, it allows you to avoid selling stocks during poor market conditions.
For more information regarding this topic, please contact Henssler Financial at 770-429-9166 or [email protected].