Reduce rate risk with bond ladders
Putting fixed income into clients’ asset allocations can be challenging now, with yields depressed and the threat of rising interest rates that would devalue bonds, but one possible solution is to build a bond ladder.
“We use bond ladders as our primary tool for clients,” says Stan Richelson, founder of Scarsdale Investment Group in Blue Bell, Pa. “They reduce the damage of interest rates spiking up and down.”
A traditional bond ladder consists of individual issues set to mature at regular intervals, perhaps one year. Proceeds from maturing bonds are reinvested to form another rung and maintain the ladder.
With, say, a seven-year ladder, clients will wind up with a set of bonds that were all bought at seven-year maturities, if that is what advisers believe to be a good risk/reward spot on the yield curve. When rates fall, forcing reinvestment at lower yields, the remaining rungs on the ladder deliver now-above-market payouts; when rates rise, proceeds from maturing bonds can be reinvested at the higher yields.
Other applications of bond ladders have emerged. Some advisers have clients spend the maturing bonds’ proceeds while portfolio assets are liquidated to purchase a replacement rung, at the longest end.
“I use ladders for clients who are in and near retirement,” says Sheila Padden, a CFP and the founder of Padden Financial Planning in Chicago. “I mix [certificates of deposit] and bonds, depending on the yields available.”
Padden’s clients have ladders ranging from five to 15 years.
“At a minimum, the ladder rungs produce enough cash to close the gap on income shortfalls for basic living expenses,” she says. “We also may use ladders for required minimum distributions from retirement accounts.”
The drawback of ladders is concentrated credit risk, Padden says.
“Therefore, I use CDs that are insured by the FDIC and Treasury strips,” she says. “Safety trumps yield in securing cash flows for living expenses.”
Treasury strips are zero-coupon securities derived from Treasury issues.
If the near-term bond or CD is liquidated and spent, where does the next rung come from?
“Hopefully, stocks outperform CDs/bonds, and equities become over weighted. We sell stock mutual funds to buy the next rung of the ladder,” Padden says.
PAYING A PREMIUM
Today, creating a bond ladder or adding an annual rung might mean paying a premium for older bonds with higher coupons than those issued now. If clients object to paying, say, $1,200 for a bond that eventually will be redeemed for $1,000, advisers can explain that the higher coupon payout will more than offset the locked-in loss of value.
In addition, Ira Fateman, principal at SAS Financial Advisors in San Francisco, points out that premium bonds have shorter durations, due to greater cash payouts.
“Therefore, in a rising interest rate market they hold up better,” he says.
Most of Fateman’s ladders hold California municipal bonds in taxable accounts and Build America Bonds, which are taxable munis, in retirement accounts.
“I can get better prices on municipal bonds,” Fateman says. “It’s harder to get good prices on investment-grade corporate bonds.”
This story is part of a 30-30 series ways to build a better portfolio.