How to Protect Yourself from This Market Now
What’s a Bond Ladder
Creating Your Bond Ladder ---
Market bottoms are a process; they don’t happen overnight. Even if last week turns out to be the market bottom, it’s unlikely the market will go straight up from here—we’re much more likely to see several more weeks or months of volatility, including multiple re-tests of the lows hit in the past two weeks.
If you’ve already raised cash and sold your weakest positions going into this week—as Cabot’s analysts have been telling our members to do for weeks—you might be wondering what else you can do to protect yourself from this market. You could put on a short position against one of the major indexes, as our value analyst recently recommended, or you could follow our options analyst’s advice and take advantage of the heightened volatility with puts and calls.
However, if you’re looking to add some predictability and stability to your portfolio—and like the idea of getting regular income—the best fit for you might be something called a bond ladder.
A bond ladder is a fixed income investing strategy that works particularly well in rising interest rate environments. I recently added one to the Cabot Dividend Investor portfolio, and Cabot Benjamin Graham Value Investor Chief Analyst Roy Ward also recommends a bond ladder in his portfolio.
What’s A Bond Ladder?
Bond ladders are a way of creating your own adjustable-rate income stream, by buying a series of bonds or bond funds with staggered maturity dates. Then, as each security matures, you reinvest the proceeds in a new security at the top of ladder, which becomes your new longest-dated security. If interest rates are rising, the new investments will have higher coupon rates than the investments rolling off the bottom of the ladder, and your yield will gradually rise.
Roy and I both recommend shorter-term bond ladders right now, made up of securities maturing at roughly even intervals over the next five years or less. While longer-term bonds yield more, shorter-duration fixed income investments carry less interest rate risk. In other words, if you expect rates to go up soon, you don’t want to be stuck holding a bunch of very low-yielding fixed income investments for a long time.
The most important part of creating a bond ladder that will preserve your capital and work in a rising rate environment is that you only buy individual bonds or defined maturity bond funds. Unlike standard bond funds—which are likely to be a poor store of value as interest rates rise because their existing holdings will lose value while their new purchases become more expensive—bond funds (or ETFs) with maturity dates preserve your principal guarantee, the promise that you’ll get your principal back when the bond matures. Note that for this to work, you have to buy securities with principal dates you’ll be around for, and not pay (much) over face value. If you buy the bond or fund for above-redemption value, you’ll lose some of your initial investment by the time it matures.
Creating Your Bond Ladder
In Cabot Dividend Investor, I recommend that members use Guggenheim BulletShares ETFs—a group of defined-maturity bond ETFs—to create their bond ladders for a couple reasons. One, buying individual bonds can get expensive, because it’s hard to buy small (or even medium-sized) dollar amounts of most bonds. In addition, these funds are easier to buy and sell than individual bonds, which often have very low liquidity.
Guggenheim offers two series of BulletShares ETFs, one that holds investment grade corporate debt and one that holds high yield (or “junk”) debt. The high-yield ETFs obviously yield more, but there’s a higher risk that some of the securities in the ETF will default, causing the fund to lose value. And an adverse credit event, while unlikely, could cause a cascade of defaults and a sharp decline in the high yield funds’ values and yields.
Guggenheim offers high yield and investment grade ETFs for each year, and you can mix and match them to meet your own risk tolerance and yield requirements. Just make sure that the funds you choose mature at roughly even intervals over the next five years or less. For example, a four-year ladder beginning in 2016 would consist of equal investments in the ETFs maturing in 2016, 2017, 2018 and 2019.
Each ETF matures at the end of the year indicated in the fund’s name. Most of the bonds in the fund will mature over the course of that year, and Guggenheim will keep the redeemed funds in cash or equivalents until the end of the year.
On or around December 31, the fund’s assets will be distributed to shareholders. The final net asset value of each fund should be close to the NAV of the fund at inception, and is usually slightly above it. Guggenheim’s investment-grade funds had a NAV at inception of $20, and the high-yield funds had a NAV of $25. You can consult the current NAV of the specific fund you’re buying to learn whether the fund is trading above or below your likely redemption price.
When the first maturity in your ladder arrives, you can keep your bond ladder intact by reinvesting the redemption value into a new security at the top of the ladder. This will maintain your income stream—and if rates are rising, it will grow over time. And perhaps even more important today, your bond ladder will provide stability and predictability to your portfolio, and protect your hard-earned cash.
Your guide to a secure retirement,
Chloe Lutts Jensen,
Chief Analyst, Cabot Dividend Investor
