Building a laddered bond portfolio has been made significantly easier thanks to ETFs.
The key on these structures is using them appropriately given their drawbacks.
We utilize these structures in our marketplace service by allocating our safe bucket cash to them.
Sequence of returns risk can be substantially mitigated, while still generating a 3%+ yield to maturity on that capital.
One of the advantages provided by the expansion of exchange-traded funds (ETFs) is the tools that it gives investors in portfolio construction. There have been so many ETFs launched in the last several years that they now outnumber the number of actual stocks that are publicly traded.
One of the ideas we have been hammering our members about is the threat of sequence of returns risk in, or as you approach, retirement. That is, having a safe bucket that helps to buffer your portfolio during the next correction. If you are withdrawing money from your portfolio for your lifestyle needs and the market corrects, the money pulled is not there to participate in the rebound. This results in a permanent impairment of your capital.
In the past, most individual investors either did not have the total portfolio value to properly construct a bond ladder or the know-how to build one. Most bonds' par value is $1,000, meaning you would need approximately $30,000-40,000 per maturity to adequately diversify your portfolio. That would require nearly $500,000 in this one bucket.
In the last half decade, two companies have developed tools to construct laddered bond strategies that are available to the masses. Invesco (recently acquired from Guggenheim) and BlackRock both have a suit of bond ETF that mature on a certain date. Most bond ETFs and funds have a range of bond maturities, and as bonds get called or mature, they are reinvested. Instead, the strategy on these bond products is that they contain bonds that are maturing or will be called in a certain year.
From the BlackRock website -
- Mature like a bond: The bonds are mature in a short range of time typically in the same calendar year.
- Trade like a stock: The ETFs of these iBonds have intraday liquidity and trade on an exchange instead of trading individual bonds OTC.
- Diversification from a fund: Through one transaction, you get the diversification of hundreds of bonds.
The goal of each iBond is to achieve a yield-to-maturity that is very close to that of the underlying individual bonds. The YTM is maintained by paying out a monthly distribution and then a final end-date distribution. While the distributions are variable, the changes to NAV help offset and preserve the targeted YTM.
Both fund companies offer targeted corporate bond ETFs at relatively low cost at just 10 bps. In addition to investment grade corporate bonds, BlackRock offers a suite of municipal bond ETFs with a designated maturity date for ~18 bps. Invesco. on the other hand. offers high yield bonds with a similar structure (and at a higher cost of ~40 bps).
Shown in the table below is the iShares suite of funds:
And the comparable BulletShares funds from Invesco:
How To Use Them
Today, given the run in the markets over the last decade, and indicators that to us point to being in the latter innings of the cycle, we are making preparations. Those preparations include bolstering our safe bucket so we are not withdrawing from our portfolio during a down market. This is because if you're in an equity-heavy portfolio and are withdrawing during a bear market, you can be digging yourself a large hole from which you likely won't be able to recover. And we think a lot of investors are very equity-heavy today, with dividend stocks and low (and rising) yields in bonds pushing them there.
The next bear market is likely to be another 50%+ decline. We've moved up 302% since the March 2009 lows. The next bear market, we believe, is likely to be similar to the last two or greater.
Our marketplace service is dedicated to helping do-it-yourself investors and advisors (a significant percentage of our membership base are financial advisors) think of their portfolios holistically and not just throw out stock recommendations.
The basis is to match spending each year with income - a no touch of the principal strategy. Cash flow investing at this point in the cycle, after significant capital gains have already been realized, makes sense to us.
These new ETFs can help offset the decline by allowing you to forgo the withdrawals during the bear market. The typical decline lasts 18 months, and it typically takes at least another 18 months to recover 50% of the decline. Thus, we like to have at least 3 years' worth of spending set aside at this point. In other words, if you have a spending need of $100,000 per year from your portfolio, you would place approximately $97,000 into the 2019 maturity ETF (matures at $100K at 3% interest), $94,250 in the 2020 fund, and $91,500 in the 2021 fund. At each of those maturities, you would have your $100,000 without having to touch the principal of your equity portfolio.
One of the primary ways investors can use these tools is as a cash substitute. A negative aspect of these structures is that as they close in on the maturity date, the amount of cash builds in the portfolio, reducing the yield and performance (cash drag). This is a byproduct of the fact that not all the bonds mature on the same date, as opposed to an individual bond portfolio where the proceeds of one bond that matures can immediately be reinvested into a new bond.
But here is where it can be an advantage for retirees. The amount of capital in the near-term ETF (i.e., the iShares iBonds Dec 2018 Term Corporate ETF (NYSEARCA:IBDH) is typically what is to be spent that year for lifestyle expenses. The cash build-up helps to reduce overall risk (even though risk is low to start with), and the investor can sell the fund at any time, not having to wait until maturity.
Both Invesco and iShares (BlackRock) have a bond ladder construction tool on their respective websites. This can help you assess what this bucket in your portfolio is doing. We selected a 2019-2022 blend (four years of cash), which we would use for very risk-averse investors.
The site shows the yield and the duration of the portfolio, along with the expense ratio. The yield being over 3% with very little cost, we believe, is a substantial benefit.
The risk of loss from these portfolios is very low, given the credit quality being all investment grade. What we've seen many portfolio managers do over the past several years is overweight BBB-rated corporates at the expense of the higher-rated stuff. The funds above have less than half of their holdings in BBB (~41%), with double-and-single A accounting for the rest. (There are only two AAA-rated corporates left: Johnson & Johnson (NYSE:JNJ) and Microsoft (NASDAQ:MSFT)).
Utilizing these new ETFs, despite their many flaws - which include the cash drag primarily - can help mitigate sequence of returns risk. By allocating the cash need for each year into the appropriate maturity ETF, you can avoid the prospect of having to withdraw capital (sell at lows) during a bear market.