An ETF Bond Ladder for Rising Income
05/02/2014 10:00 am EST
J. Royden Ward cautions that investors should prepare for a bear market in bonds, which will lead to rising interest rates. In this environment, the editor of Cabot Benjamin Graham Value Investor suggests a bond laddering strategy for income investors.
Steven Halpern: Joining us today is value investing expert, Roy Ward, Editor of Cabot Benjamin Graham Value Investor. How are you doing today?
J. Royden Ward: I am doing fine, Steven. The market is up, so I am feeling good.
Steven Halpern: You point out that the recent bond bull market started over three decades ago and that we could be heading into a new bear market in bonds. Could you explain the forecast and the background for that forecast?
J. Royden Ward: Yes, sure. If you look at the long-term chart of the 10-year Treasury Bond, you will find that the Treasury Bond went through a huge bear market from about 1950 to 1981, a period of 31 years and, while bond prices were declining, of course, interest rates went up.
Around 1950, or a little before, the interest rate on the 10-year was about 2%, it rose to 15.8% and peaked in 1981, but since 1981, we have had a big bull market in bonds, which has sent the interest rate on the 10-year from 15.8% down to 1.4% in mid-2012.
Since then, the interest rate on the 10-year US Treasury Bonds has risen a little bit from 1.4% to about 2.7% now. I think that rise in interest rates and fall in bond prices is going to continue. I think we started on another long-term bond trend.
Steven Halpern: Now, it may seem counter-intuitive, but your caution regarding bonds is, in part, based on a growing confidence in the economic recovery. Could you explain that?
J. Royden Ward: Yes, the US economy is improving—it is slow—but it continues to improve. The job market is getting a little better. We have had a strong rebound in the housing market and, of course, the rise in the stock market during the last several years has added to individual wealth.
When economic factors improve, interest rates tend to rise, bond prices fall, and I think that is where we are at now. I think the economy will continue to improve, which means bond prices will probably fall.
Steven Halpern: Now, in the current environment, you are not recommending bond funds or bond ETFs, yet you still believe that investors can make money in the bond market and you point to a strategy called bond laddering. For our listeners who are not familiar with that term, could you explain the concept of bond laddering?
J. Royden Ward: Yes, when you buy a bond, it has an expiration date. In bond laddering, what you can do is invest in a one-year bond, or a bond that is going to expire in one year, and also a two-year, a three-year, a four-year and maybe a five-year bond, so that you will have bonds expiring in each of the next, let’s say, five years.
That is what is referred to as bond laddering. Now, when the first one-year bond expires in one year, you do not replace it with a one-year bond, you replace it with a, lets say, a five-year bond so that you keep the ladder going, so you have always got bonds expiring every year for the next, well, five years and then beyond.
Steven Halpern: If rates do rise as you expect, when somebody does this type of ladder, as the bonds come due, they will be reinvesting those proceeds into higher yielding bonds further out in that ladder, is that correct?
J. Royden Ward: Yes, that is correct. A one-year bond is going to have a relatively low yield, whereas a five-year bond is going to have a slightly higher yield. If bond prices go down and yields go up, why, the difference between a one-year and a five-year could be quite a bit.
Steven Halpern: Now, in your latest research, you look at what are called “defined maturity bond funds” as a way to undertake this type of laddering approach. Could you explain these defined maturity bonds and how an investor would use them to create a ladder?
J. Royden Ward: Yes, there are bond funds, mutual funds, and bond ETFs available that have expiration dates, so you can buy, for instance, an ETF, a Guggenheim ETF, that will expire in one year. You can buy another one that expires in two years, etc., to fulfill your four or five-year bond ladder.
That makes it a lot easier for the investor, rather than buy individual bonds, which, oftentimes, have minimum investment requirements of $10,000 per bond. You can buy a pool of bonds with money bonds in an ETF or bond fund, which makes it easier and you get more diversification.
Steven Halpern: You mentioned the name Guggenheim, and that is a fund family. I believe the funds that you have been looking at are called the Guggenheim Bullet Shares.
J. Royden Ward: Yes, that is right. Those are exchange-traded funds. They trade every day on the stock exchanges and they have expiration dates, so you can buy a one-year, two-year, three-year, etc., up to, I think, six or seven years, and so, you can build a ladder with the Guggenheim Bullet Shares, which I have been recommending in my Value Investor.
J. Royden Ward’s Recommended Funds for Laddering
Guggenheim 2014 HiYld Corp Bond ETF (BSJE)
Guggenheim 2015 Corp Bond ETF (BSCF)
Guggenheim 2016 HiYld Corp Bond ETF (BSJG)
Guggenheim 2017 Corp Bond ETF (BSCH)
Guggenheim 2018 HiYld Corp Bond ETF (BSJI)
Steven Halpern: That is a fascinating approach. We really appreciate you taking the time today and for sharing this strategy with us.
J. Royden Ward: Oh, you are welcome, Steven. Glad to talk to you.