Editor’s Note: The following guest column is written by my friend Jim Oswald. Jim is a very smart, self-made guy that understands the bond market as well, if not better, than anyone I know. Although the information in Jim’s column is much more bond market-specific than the financial market analysis and directional forecasting that we do at Asbury Research, I think many managers and investors will find it both educational and useful.
By James Oswald, CFA
Asbury Research and I share a common goal; provide what’s best for the investor. John Kosar, from Asbury, and I have had many conversations pertaining to markets, business, analytical methods, shared values and sometimes politics (we’re only human.)
I have been involved with investments since the late 1970s. My grandfather and a close neighbor were two of my mentors. My neighbor introduced me to charting and many investment concepts. My grandfather shared his knowledge of business and investments. During the summer I was charting on paper, watching a local Chicago daily broadcast from the Chicago Board of Trade and reading the business section while my brother focused on the sports section and baseball. During those years, my passion and interest motivated me to attend university at night, earn a Bachelor’s degree in finance and obtain the Chartered Financial Analyst (CFA) designation.
John Kosar and I thought sharing my fixed income expertise would be beneficial to many of his clients. I hope you find these guest articles useful.
Introduction to Bond Ladders
An investment portfolio should be constructed to achieve a series of cash outflows either to be withdrawn or reinvested. Withdrawals are based on specific cash needs and can be periodic or onetime. Reinvestments provide a form of dollar-cost-averaging since future returns are unknown.
Unlike most other investments, bonds contractually state the amounts and dates of each cash flow. A bond ladder composed of individual bonds takes advantage of this unique bond characteristic by purchasing a portfolio of bonds designed to achieve specific future cash flows. The ladder can be constructed as a distribution strategy or as an accumulation strategy. A distribution strategy is used to replace or supplement other income such as social security benefits. An accumulation strategy is used to mitigate interest rate risk and provide reinvestment flexibility.
This is a simple example. The ladder can be customized based on an individual’s cash needs and/or time horizon. In a distribution strategy the total cash is withdrawn for spending. For an accumulation strategy in each year the total cash is reinvested into a new bond with a maturity one year greater than the longest. For example in 2018 the $125,050 will be used to purchase a bond with a maturity year of 2031.
Starting to Build
Credit risk tolerance and tax considerations determine the allocation to the type of bonds i.e. U.S. Treasuries, CDs, corporate bonds, municipal bonds, etc. The amount invested in a bond ladder is dependent on whether the investor chooses a distribution or accumulation strategy.
A distribution strategy prioritizes certainty of cash flows and this need determines the bond ladder allocation while the stock allocation is a residual.
An accumulation strategy’s bond ladder and stock allocation is a function of the normal asset allocation strategy based on time and risk tolerances. The bond ladder provides portfolio diversification and is designed to mitigate interest rate risk of the bond allocation, especially during periods of rising rates.
Most individual investors utilize commingled investment products (open-end and closed-end mutual funds, exchange traded funds “ETFs”) in order to diversify their portfolio and set their bond allocations based on risk, time to cash need etc. These products are generally managed in order to produce similar risk and return of a specific index such as the Barclays Aggregate Bond Index. These products are designed to be easy to use and try to overcome the comparative illiquidity of individual bonds. However, allocations to these products do not take full advantage of the unique predictable cash flow characteristic of bonds.
It takes a significant amount of time, oversight and expertise to analyze individual bonds and price a bond relative to other investment options. This is one reason it is recommended that individual investors only utilize U.S Treasuries and FDIC insured certificates of deposit “CDs” when building a bond ladder. For more complex portfolios it might be beneficial to utilize an investment advisor that has bond expertise to help an investor determine the strategy, build, and maintain a customized bond ladder.
In my next articles I will address the details into customizing, building and maintaining a bond ladder, execution and trading issues.
Disclaimer: Information presented is for educational purposes only and the author does not intend to make an offer or solicitation for the sale or purchase of securities. Investments involve risk and are not guaranteed.