There’s a rule of thumb that says retirees should invest the majority of their portfolios in bonds. Matt Tucker explains why bonds are just the beginning, and shares tips for building a bond ladder
When it comes to investing in bonds, we know that bond laddering is a common strategy used when building a portfolio. By buying a portfolio of bonds of different maturities, an investor can spread out interest rate risk and create a stream of cash flows for income. Today I want to talk through an example of how to construct a bond ladder and what it might look like.
To help with today’s discussion, I have invited my fictitious neighbor Bob to join us. Bob is 60 years old, retired and has some investments. He is looking to allocate a portion of his portfolio to income assets, and is evaluating how to invest it. Bob is looking for regular income, and also wants an investment that has less risk than his equity assets, a common goal among retirees at this stage in life. For an investor like Bob, building a ladder using either bonds or ETFs could be a good solution.
In a classic bond ladder, Bob would buy a range of bonds with maturity dates that are spread out evenly across different years. Each year, one of the bonds will mature and the maturity payment can be used for a large purchase (such as buying an RV) or reinvested into another rung of the ladder. Traditionally bond ladders have been built with individual bonds, but this can be challenging for a number of reasons.
- It can be difficult and time consuming to find the right bonds for your portfolio. There is no exchange that Bob can go to; instead he has to work through a broker and try to track down the bonds that will fit into his ladder.
- Transaction costs for individual bonds can be quite high. In general, when it comes to bonds, the smaller your trade, the higher the level of transaction costs you pay. This puts individuals like Bob at a big disadvantage relative to larger, institutional investors.
- Diversification can be hard to come by. Bob doesn’t want to only own a handful of bonds because it would leave him very exposed if one of the bond issuers defaulted. Ideally he would buy a lot of individual positions to spread out his risk, but this can be difficult due to the aforementioned points.
There is an alternative to using individual bonds. My team and I recently expanded a series of term maturity exchange traded funds (ETFs) called iBonds®. iBonds are ETFs that have a defined maturity date like a bond, are diversified like a mutual fund, and trade on an exchange like a stock. They are designed to be used by investors like Bob to create cost efficient laddered solutions.
A visual example of building a bond ladder
If Bob wanted to build out a 10 year ladder using iBonds, he could invest an equal amount of money into each of the funds maturing in years 2016 through 2025. Here is an illustration:
Source: Barclays and BlackRock Solutions
Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
The graph shows a range of corporate bond maturities and the level of yield available in the market. If Bob were to invest equal amounts into these 10 iBonds, he could expect to receive monthly cash flows as the iBonds at each rung of the ladder are scheduled to distribute any income on a monthly basis. (Unlike a single bond, distribution amounts from iBonds ETFs will vary.) And every year starting 2016, one of the iBonds would mature and Bob would receive a lump sum payment. He can then spend that payment, or reinvest it in the next rung in the ladder.
For investors like Bob who are looking to build bond ladders, term maturity ETFs provide a new tool for building a robust investment solution.
Matthew Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog. You can find more of his posts here.
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Investing involves risk, including possible loss of principal.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.
The iShares® iBonds® ETFs (“Funds”) will terminate on or about March 31 or December 31 of the year in each Fund’s name. An investment in the Fund(s) is not guaranteed, and an investor may experience losses, including near or at the termination date. Unlike a direct investment in a bond that has a level coupon payment and a fixed payment at maturity, the Fund(s) will make distributions of income that vary over time. In the final months of each Fund’s operation, as the bonds it holds mature, its portfolio will transition to cash and cash-like instruments. As a result, its yield will tend to move toward prevailing money market rates, and may be lower than the yields of the bonds previously held by the Fund and lower than prevailing yields in the bond market.
Following the Fund’s termination date, the Fund will distribute substantially all of its net assets, after deduction of any liabilities, to then-current investors without further notice and will no longer be listed or traded. The Funds’ distributions and liquidation proceeds are not predictable at the time of investment and the Funds do not seek to return any predetermined amount.
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