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Step up to Bond Ladders

05/15/2019 5:00 am EST

Focus: BONDS

Tim Plaehn

Investment Research Analyst, Investors Alley

In my earlier days as a financial advisor, conservative fixed income investors would build a “bond ladder” portfolio to generate a high current yield, but not have all of their money locked into the long term bonds which paid the highest yields, notes Tim Plaehn, income expert and editor of The Dividend Hunter.

The idea of bond ladders fell out of favor with the rise of bond ETFs and index funds. Bond funds work great when interest rates are declining, which they have been since the U.S. 10-year Treasury reached a peak yield of 15% in Fall of 1981.

However, lost in the fog of history is that rising interest rates are terrible for bond funds. In a rising rate world, bond fund prices fall and by reasons of math and how the funds are structured, cannot recover the lost value.

Investors who have put billions into bond ETFs and index funds are in for a rude awakening when the day comes that longer term interest rates start into an extended up trend. We have not seen it yet, but everything goes in cycles, and I strongly expect the same to happen with bond yields.

The bond ladder strategy avoids the danger of falling bond prices in a rising rate world. That’s because the bonds are held until maturity when the face value will be paid off. (That’s what could hurt bond funds. They don’t hold bonds until they mature).

To provide liquidity and an attractive yield, a bond ladder is established by buying a portfolio of bonds with laddered maturities. For example, the investment capital would be split between five bonds, each maturing in each of the next five years.

Once the ladder is set up, there will be a bond or bonds maturing every year. The principal can be reinvested at the longest term of the ladder, which when the yield curve is normal, will pay the highest yields.

In a hypothetical world of yields that don’t change and a positively sloped yield curve, a bond ladder will have an increasing yield over time as maturing bonds get reinvested. If rates are rising the latter will generate strongly increasing income without putting the principal at risk. A good deal.

For the Dividend Hunter Fixed Income Investments section, I recommend setting up a “bond” ladder using the Invesco Investment Grade BulletShares ETFs.

These are ETFs which have portfolios of investment grade bonds with each individual ETF having a fixed maturity at the end of each year. There are separate ETFs with terms of one to 10 years. These funds allow you to set up a low cost, diversified bond ladder.

Here are some of the BulletShares features:

• Extremely stable share prices. The fixed maturities ensure to that.

• Shares are extremely liquid. ETF shares are easy to buy or sell in your brokerage account. Some brokers (I know Schwab is one) do not charge commissions to buy or sell these ETFs.

• Monthly dividends. Which can be automatically reinvested to compound the investment returns.

• Higher yields than you can get from money market types of accounts or funds.

And once you buy the shares, yields are locked in until maturity. My recommendation is to put a portion of your portfolio into a five-year ladder of the BulletShares ETFs.

I strongly suggest you set up automatic reinvestment of the monthly dividends. I view this portion of your portfolio as a type of emergency fund that you can tap into when the stock market cycles through the next bear market.

When stock prices start falling rapidly, you will be better served by reinvesting your stock dividends into shares of our quality dividend paying stocks and selling BulletShares shares for the money you need to pay your retirement expenses.

Setting aside money to cover a year of your living expenses could be something you are very thankful for at some period in the future.

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