A Bond ETF Income Ladder

09/23/2015 9:00 am EST

Focus: ETFs

Chloe Jensen

Chief Analyst, Cabot Dividend Investor

We’re adding an ultra-conservative position to our safe income portfolio—a modified bond ladder composed of four separate ETFs—suggests Chloe Lutts Jensen, editor of Cabot Dividend Investor.

This bond ladder should provide some counter-exposure to the stock market as well as a growing income stream over time while preserving our capital and reducing our risk.

Bond ladders are a way of creating your own adjustable-rate income stream, by buying a series of bonds or bond funds with staggered maturity dates.

Then, as each security matures, you reinvest the proceeds in a new security at the top of ladder, which becomes your new longest-dated security.

If interest rates are rising, the new investments will have higher coupon rates than the investments rolling off the bottom of the ladder and your yield will gradually rise.

It is important that you only buy individual bonds or defined maturity bond funds for your ladder, to preserve your principal guarantee.

In times of rising interest rates, standard bond funds are likely to be a poor store of value, because their existing holdings will lose value while their new purchases become more expensive.

Investing in bonds or ETFs with maturity dates, on the other hand, preserves your principal guarantee, the promise that you’ll get your principal back when the bond matures.

We’re going to keep things simple and use Guggenheim BulletShares ETFs, a group of defined-maturity bond ETFs; these funds are easier to buy and sell than individual bonds, which often have low liquidity.

Guggenheim offers two series of BulletShares ETFs, one that holds investment grade corporate debt and one that holds high yield (or junk) debt.

The high yield ETFs obviously yield more, but there’s a higher risk that some of the securities in the ETF will default, causing the fund to lose value.

I feel comfortable buying high yield ETFs for two of the rungs of our bond ladder, the securities maturing in 2016 and 2018.

For the other two rungs we’ll buy Guggenheim’s investment grade ETFs (they’re simply called “corporate bond” ETFs) maturing in 2017 and 2019.

If you have a lower or higher risk tolerance, feel free to adjust your own bond ladder accordingly; Guggenheim offers high yield and investment grade ETFs for each year.

Guggenheim’s investment-grade funds had a NAV at inception of $20 and the high-yield funds had a NAV of $25. The four funds we are buying are:

Guggenheim BulletShares 2016 High Yield Corporate Bond ETF (BSJG)—Current yield: 3.4%

Guggenheim BulletShares 2017 Corporate Bond ETF (BSCH)—Current yield: 1.4%

Guggenheim BulletShares 2018 High Yield Corporate Bond ETF (BSJI)—Current yield: 4.3%

Guggenheim BulletShares 2019 Corporate Bond ETF (BSCJ)—Current yield: 1.8%

Note that the last letter in each ETF corresponds to the maturity year, so if you’re putting on a four-year ladder starting in 2016, your four funds should end in G, H, I, and J, whether high yield or investment grade funds.

The current combined yield of these four positions is about 3.4%. Note that while the funds’ regular monthly distributions are classified as ordinary income, the funds may also make small distributions of short- and long-term capital gains at the end of each year.

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