Five Steps to a Bond Income Ladder
04/27/2015 10:00 am EST
Value investor J. Royden Ward, editor of Cabot Benjamin Graham Value Investor, explains how to create a bond ladder made up of five exchange-traded funds. This conservative strategy is designed to generate rising income should interest rates increase in coming years.
Steven Halpern: Our guest today is J. Royden Ward, editor of Cabot Benjamin Graham Value Investor. How are you doing today, Roy?
J. Royden Ward: I’m doing great, Steve, how about you?
Steven Halpern: Very good. Thank you so much for taking the time. Today we’re going to discuss income investing through a strategy, that you’re an expert on, known as bond laddering. First, could you explain the long-term nature of the bond price cycle and why you believe we could be heading into a new bear market in bonds?
J. Royden Ward: Sure. Bond cycles tend to be very long. The recent bond bull market started 34 years ago in 1981 when the interest rate on the 10-year US Treasury bond was way up at 16.8%, so that was a very long bull market in bonds. We could be headed into a new bear market in bonds. The interest rate on the 10-year Treasury bond has risen from 1.4% in July 2012 to 1.9% now.
That’s not too much of a move, but I think the bond interest rates will continue to rise slowly and the reason I say that is the economy is improving, the job market looks solid, we’ve had a strong rebound in the housing market, and also, the vigorous rise in the stock market has all been bullish.
So when economic factors improve—why interest rates rise but bond prices fall—so I think the bond market will continue in a downward direction as far as bond prices are concerned in the foreseeable future.
Steven Halpern: Could you explain the overall structure and the logic behind the bond ladder?
J. Royden Ward: Yeah, a bond ladder is a portfolio of bonds, which have varying terms to maturity. Ben Graham advocated holding at least 25% of your investments in bonds, which I think is good advice.
Investing in several bonds with different maturity rates—and dates—rather than in one bond with a single maturity date will minimize your interest rate risk and increase your liquidity and diversification.
To create a five-year bond ladder for instance, you would buy a bond that matures in one year, another bond that matures in two years, then one in three years, four years, and finally five years.
As bonds in the ladder portfolio mature, you can reinvest in new bonds with the proceeds from the matured bond and invest in a bond that is one year longer than the longest maturity in the ladder. For example, when the one year bond matures a year from now, buy a five year bond to maintain the five year ladder.
Steven Halpern: Now rather than using individual bonds or bond funds to implement this strategy, your vehicle of choice is what’s called defined maturity funds. Could you explain this?
J. Royden Ward: Defined maturity funds seek to strike a middle ground between individual bonds and bond mutual funds. Like individual bonds, these defined maturity funds mature on a specific date and return the capital shareholders on that date, or slightly thereafter, and they’re also like bond mutual funds.
They are professionally managed and benefit from a diversification that a large portfolio offers. You can build the equivalent of a bond ladder by investing in defined maturity funds with ladder style maturity dates.
Steven Halpern: To put that into specific terms that an investor could follow, you are recommending a series of exchange-traded funds on Guggenheim, which are known as BulletShares. Could you explain how these work?
J. Royden Ward: Certainly. Guggenheim offers two categories of defined maturity funds. They have a category of bulletshare ETFs that contain high-grade corporate bonds, which are rated investment grade and they also have another sector of bulletshare ETFs which hold high yield lower grade corporate bonds.
The Guggenheim BulletShares are exchange-traded funds, or ETFs, which can be bought and sold just like stocks to any broker throughout the trading day.
There is no minimum investment beyond the prevailing share price.
BulletShare ETFs hold 100 or more corporate bonds in each ETF. Distributions are paid by Guggenheim monthly, which can be reinvested in additional shares or taken as cash.
Guggenheim offers ten high-grade corporate bond ETFs with maturity dates ranging from 2015 through 2024 with yields of 0.5%, which is pretty low, to 3%. The management on this sector of ETFs is 0.24%, or about a quarter of 1%, which is reasonable.
Guggenheim also offers eight high yield, lower grade corporate bond ETFs with yields of 4.4% to 5.5%. Management fee is a little higher at 0.44%, but that is still very reasonable.
Steven Halpern: For somebody looking to implement this five year strategy, or five year ladder, would you begin with 2015 corporate and go out to 2019, or would somebody starting now buy the 2016 and then go out five consecutive years?
J. Royden Ward: Well, you can go either way with that, Steve. Right now, I would invest in 2015 through 2019 and I’ll give you a few examples of the ETFs that I’ve been recommending.
For the 2015 maturity date the Guggenheim 2015 Corporate Bond ETF with a symbol (BSCF), which is their high grade ETF, currently yields 0.47% or less than 0.50%, so you can see short-term with high grade, the yield is real low.
I am also recommending the Guggenheim 2016 High Yield or low quality corporate bond ETF with a symbol (BSJG). The yield on that is 4.07%, so with the lower quality bonds, you’re going to get a lot higher yield.
Then I’m also recommending the Guggenheim 2017 Corporate Bond ETF and that’s the high quality and the symbol is (BSCH). The yield on that is 1.09%, which is…now you’re starting to see a step up as we go longer out.
Another ETF that I’m recommending is the Guggenheim 2018 High Yield Corporate Bond ETF and that’s the lower quality one and it has a symbol (BSJI) and the yield on that one is 5.41%, currently.
Finally, for my 2019 maturity, I recommend the Guggenheim 2019 Corporate Bond ETF, with a symbol of (BSCJ) and that’s the high quality. The yield on that one is 1.83%.
Overall, with those five BulletShare ETFs, I’m recommending three that are high quality and two that are lower quality and the average yield on those five ETFs is 2.57%, which isn't too bad.
Then, when that 2015 ETF comes due at the end of this year, Guggenheim will deposit the proceeds of the bond fund into my brokerage account, and what I’ll do is turn around and buy the 2020 ETF, and I might buy the corporate bond high quality or I might buy the high yield lower quality corporate bond ETF. That’s how they work.
Steven Halpern: If interest rates rise over time, you’ll then be reinvesting the near term proceeds into a higher yielding position, and over time, if rates rise, your overall return will go up.
J. Royden Ward: That’s exactly right. Once I get into the five ETFs, from this point on, every year I’ll be buying a new five year ETF, which will have a higher yield than the one or two year ETFs.
Steven Halpern: Well, it’s a fascinating strategy and very important for people to understand, particularly in the low interest rate environment we’re in. Thank you so much for taking the time to talk with us today.
J. Royden Ward: Oh, you’re welcome Steve. I’m glad to do it.