RVW Investing: The Five Year Laddered Bond Portfolio

By Selwyn Gerber of RVWInvesting:

Chapter 12: THE 5 YEAR LADDERED BOND PORTFOLIO

 

Bonds come in many flavors: taxable or tax free; Treasury; junk; and many others. For affluent investors, holding individual bonds is usually preferable to bond funds. Bond selection requires more thought than ETF index selection.

 

Fixed income investors have been paralyzed by the fear of rising interest rates. Many investors have elected to hold cash rather than to reinvest farther out on the yield curve in maturities that offer higher interest rates.

– Ed Easterling, Crestmont Research

 

Fear is a common problem among investors. Fear of missing out on stock market gains prevents some investors from holding fixed income assets. Fear that rates will rise causes some investors to delay committing to fixed income investments. Other fears factor into the asset allocation process, and all can be addressed with a relatively simple strategy.

 

TAXABLE v TAX-FREE BONDS: The best way to invest in bonds varies for each individual investor. The first question to address is related to taxes. Income tax free municipal bonds are usually attractive to investors in the upper income tax brackets. While the interest rate is lower, the after tax return may be greater, depending upon the market rates available. To do an apples-to-apples comparison, you need to convert the taxable bond’s interest rate to an equivalent after-tax rate and compare that with the tax-free bond’s interest rate. The larger value provides more income and represents the best investment.

 

Determining the equivalent after-tax rate starts with finding your marginal income tax rate, including federal, state, and local taxes. If you are in the 28 percent federal bracket, with state taxes of 7 percent, and local taxes of 2 percent, your marginal tax rate is around 37 percent. That value is used in the following formula:

 

Equivalent taxable yield =

100 *   tax free yield

100 – tax rate

 

If you were evaluating a municipal bond with a 4 percent coupon, the formula would tell us that the equivalent taxable yield is 6.34%.

 

Equivalent taxable yield =

100 *               4          = 100*(4/63) = 6.34%

                 100 – 37

 

This means if we can find a taxable bond with a yield of at least 6.34% and the safety we are seeking, it is a better investment than the 4% municipal bond.

 

For individuals in higher tax brackets, the tax-free bond often makes the better investment. This applies only to money held in taxable accounts. In tax-free retirement accounts, there would rarely be any advantage to municipal bonds.

 

The issue of taxes is never straightforward and the Alternative Minimum Tax (AMT) impacts municipal bond holders. The AMT requires the interest from some municipal bonds, especially those used to fund airports and industrial projects, be counted as income for some taxpayers. A detailed understanding of the specifics usually requires the assistance of your accountant and investment advisor.

 

When holding individual bonds, taxable munis can be avoided. However, municipal bond funds may hold these bonds, which means they will regularly distribute income subject to the AMT to their shareholders. While AMT municipal bonds often pay a little more interest than other bonds, it is not enough to offset the taxes. While mutual funds or ETFs are ideal investment choices for the equity portion of your portfolio, bonds are often best bought individually.

 

HOW THE BOND LADDER WORKS: One strategy for the fixed income portion of your portfolio is known as a bond ladder. The goal of the ladder is to ensure a stable rate of return. The advantage of the ladder the ladder is that it lowers the risks associated with fixed income investments.

 

Bonds have maturity dates, which is when you get your principal repaid.. If all bond investments mature at the same time, then you are forced to reinvest for income at whatever interest rate the market is offering at that time. If interest rates fell since your original purchase, then you either receive less income or increase risk in pursuit of greater returns. That is the reinvestment risk associated with bonds.

 

Laddering involves buying bonds with differing maturities. Short-term bonds have low volatility, but lower interest rates than long-term bonds. Increasing income by investing only in long-term bonds will expose you to wide fluctuations in price, creating potential losses if you have to sell before the maturity date. Bond laddering takes some of the risk out of interest rate swings, smoothing out your portfolio income over time.

 

To build a laddered portfolio, you buy an assortment of bonds with maturities distributed over time. For example, you might invest equal amounts in securities maturing in one, two, three, four, and five years. A year later, when the first bonds mature, you would reinvest that money in a bond with a five year maturity, which maintains the time structure of the ladder. The differing maturities means that your income will be higher than you would earn if you bought only short-term issues. In effect with a five year bond ladder your average investment period is 2.5 years yet once the program has been put in place, you will always be reinvesting into 5 year bonds which tend to pay higher rates than one year or 2.5 year maturity bonds. And one-fifth of the portfolio matures each year, providing a constant and regular source of liquidity if needed. Your risk will be less than if you bought only long-term bonds. Finally, you are better protected against interest rate swings than with bonds of one maturity.

 

If interest rates decline, you will have to reinvest the principal that’s being repaid in the lower interest rate environment at a lower rate, but you will be benefitting from the above-market return offered by the other issues in your ladder. If rates rise, your total portfolio will quickly catch up as you reinvest in new bonds every year. This strategy smoothes out reinvestment risk since some money is being reinvested throughout a full interest rate cycle. The result is a portfolio with returns close to those of longer term bonds but with substantially less risk.

 

Over more than a century, five year bond ladders have never had a losing year. Since 1900, this strategy delivered an average return of 4.7% per year. The steadiness of returns for the five year ladder makes this the best strategy for almost all investors.

 

 

1900-2003

Bond Ladders

5-year

10-year

20-year

Average return

4.7%

4.9%

4.9%

Minimum return

0.4%

0.2%

-2.1%

Source: Crestmont Research

 

With laddering, there are steady returns and no tax surprises. It seems clear that investing in individual securities may be better than using a mutual fund or ETF. This is always true for investors with moderate to significant assets. An article published by discount broker Charles Schwab found that for investments of more than $50,000, bonds held to maturity are a more efficient investment than mutual funds.

 

The basics of laddered bond investing are relatively simple. It is a classic and time-tested strategy that requires discipline and removes the need for judgment. The initial implementation of this strategy is more complex than buying and holding equity ETFs. However once in place, the only actions required are to spend the interest payments and reinvest the principal each year as a portion of the portfolio matures.

About Luke Ford

Raised a Seventh-Day Adventist at Avondale College in Australia, Luke Ford moved to California in 1977. He graduated from Placer High School in 1984, reported the news at KAHI/KHYL radio for three years, attended Sierra College and UCLA, was largely bedridden by Chronic Fatigue Syndrome for six years, and converted to Judaism in 1993. From 1997-2007, Luke made his living from blogging. Living by Beverly Hills (Alexander90210.com), he now teaches the Alexander Technique (moving the way the body likes to move). Lessons cost $100 each and last about 45 minutes. In 2011, Luke completed a three-year teaching course at the Alexander Training Institute of Los Angeles. His personal Alexander Technique website is Alexander90210.com. Luke is the author of five books, including: » The Producers: Profiles in Frustration » Yesterday’s News Tomorrow: Inside American Jewish Journalism
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