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Five Things Our Clients Appreciate About Bond Ladders Thumbnail

Five Things Our Clients Appreciate About Bond Ladders

Estate Planning Investment Planning

Introduction

I thought I would eventually write this article, when the market turned south.  But having gone through an 11 year bull market, I wasn’t quite sure when that was going to happen.  However, recent events told me it was time.  

In January, one of our more conservative clients had asked me about why her accounts had ‘so much cash and bonds.’  I gently explained that it was part of our agreed-upon asset allocation, and that given the potential big events in her life, we wanted to make sure that she had available cash to take care of her needs.  She reluctantly let go of the issue, but I knew she wasn’t happy that she felt like she was missing out on a stock market run.  

In March, when the coronavirus sell-off shaved over 35% from the stock market’s all time highs with a one-month period, that same client sent me an email thanking me for keeping her investments where they were.  

But it wasn’t only her.   During the coronavirus pandemic, we reached out to each of our clients, to make sure they were safe.  When the topic eventually moved to their finances, many of them thanked us for having them partially invested in a bond ladder.  That’s when I knew it was time to write this article.

At the time of this writing, we’re talking about the stock market decline due to the coronavirus pandemic.   But truthfully, this approach worked for many portfolios during the Great Recession of 2008-2009, the ‘lost decade’ of the early 2000s, and countless other periods when stocks didn’t perform as well as investors would have liked.   While there are many technical aspects of building a bond ladder, this article sticks to the things that our clients appreciate about the bond ladders that are in their portfolios.   But first,

What is a bond ladder?

A bond ladder is a series of fixed-income instruments (bonds or CDs), that are purchased for a portfolio.   However, instead of buying one (or more) bonds with the same maturity dates, a bond ladder might have staggered maturity dates.  For example, if Joe had $100,000 to invest, and wanted to create a bond ladder over 5 years, he might buy the following:

  • 1 year bond at $20,000
  • 2 year bond at $20,000
  • 3 year bond at $20,000
  • 4 year bond at $20,000
  • 5 year bond at $20,000

Let’s fast forward a year.   Now the bond ladder looks like this (without including any earned interest):

  • $20,000 in cash (bond just matured)
  • 1 year bond at $20,000
  • 2 year bond at $20,000
  • 3 year bond at $20,000
  • 4 year bond at $20,000

Now you have options with that $20,000.  You can use it for:

  • Predetermined needs—something you had planned for in advance
  • Emergent needs
  • Reinvestment—if you don’t need the cash.

The concept is relatively simple, but you can use any variety of bonds or CDs to create a bond ladder based upon your preferences for yield, safety, duration (how far out you want your bond ladder to go), and type of instrument.

How we construct a bond ladder

Since each type of bond ladder is different, it’s worth discussing how we construct bond ladders for clients.   Since we’re relatively conservative, our primary goal is funds preservation, not investment results.   Although nothing is guaranteed (by law we cannot guarantee safety of any investment), we do focus on what is backed by federal and state governments.  Here are some of the criteria we look for:

  • In IRAs, we’re looking at CDs, up to the FDIC limit only.  No corporate bonds of ANY rating.
  • In taxable accounts, we look for highly-rated municipal bonds (Moodys AA3 or S&P AA or better).   Sometimes, we’ll look for bonds that are insured (for additional protection), or pre-refunded (callable in the future, but they’re backed by U.S. Treasuries).  We also screen against certain states and municipalities we feel might not be able to meet their future obligations.
  • While interest rates are low, our bond ladders might not go out further than 2 years.  
  • Market rates:   When our clients ask us to buy a bond or CD, we don’t sit and wait for the best price.  Because it might never come.  We simply shop for the best rates we can get at the time of purchase, and buy.  But we will wait for bonds that meet our strict criteria for safe investing.
  • Finally, and most importantly, we hold all bonds and CDs until maturity.  

This is generally our criteria, because our focus is on:

Bond Ladder Benefit #1:  Safety, Not Yield

Not every bond ladder is constructed with safety in mind.  In fact, when you research bond ladders, you might see articles that discuss how a bond ladder might generate income.  We see it a little differently.

If you have $500,000 in a bond ladder, yielding 1%, that’s $5,000 per year.  While that could be considered income, most of our clients would not consider it income that they could count on.  And if we could find riskier assets that yield 4%, our clients probably would not appreciate stretching that far, just to get $15,000 per year.  

Instead, if we invested $500,000 in a bond ladder in March 2020, it might look like this hypothetical example:

Bond/CD Name

Maturity Date

Face Amount

Interest

Bond - Des Moines IA

6/1/2020

 $     30,000 

 $     1,500.00

CD - Morgan Stanley

7/10/2020

 $     60,000 

 $     1,650.00

Bond - Fort Band TX

9/1/2020

 $     30,000 

 $        900.00 

Bond - Cincinnati OH

12/1/2020

 $     50,000 

 $     2,625.00

CD - Wells Fargo

12/14/2020

 $     42,000 

 $     1,302.00 

CD - Wells Fargo

12/14/2020

 $     54,000 

 $     1,674.00 

CD - John Marshall 

12/18/2020

 $     45,000 

 $        720.00 

CD - John Marshall 

1/11/2021

 $     34,000 

 $        544.00 

CD - Wells Fargo

3/8/2021

 $     60,000 

 $     1,740.00 

CD - Morgan Stanley 

6/18/2021

 $     31,000 

 $        837.00 

CD - Morgan Stanley 

9/30/2021

 $     30,000 

 $        526.00 

CD - Morgan Stanley 

12/13/2021

 $     34,000 

 $        595.00 

Totals

 

$500,000

$14,613

 

While you might normally focus on the amount of interest, we don’t.  Our focus is on being able to tell our client that if they need money, then:

  • $30,000 becomes available in their trust account on 6/1/2020
  • $60,000 becomes available in their IRA on 7/10/2020
  • $30,000 becomes available in their trust account on 9/1/2020

And so on.  

Our focus is not on the $14,513 they might earn interest each year.  While might be considered decent (or not decent), that’s not the goal.  It’s simply a reflection of the best interest rates available at the time we purchased these instruments.  

Our focus is on the fact that $500,000 is invested in high-quality, fixed income instruments and that they all mature within the next 2 years from our March 2020 meeting.  The only thing they have to do is…nothing.   Literally.  That leads us to our next benefit.

Bond Ladder Benefit #2:  Predictable Liquidity

A quick Google search led me to believe that this phrase isn’t very commonplace.  But it should be.  Predictable liquidity is simply knowing the schedule of when you’ll have access to cash without having to sell anything.  While this doesn’t have much of a benefit in a roaring bull market, it really hits home when the stock market just went down 30%.  

Generally speaking, one of the worst things an investor can do is sell securities into a down market.   But oftentimes, the conditions that create the down market are the ones that generate the need for cash.  For example, selling stocks during the 2008 recession could be considered foolish, but if you were one of those who lost their job, you probably didn’t have much of a choice.

A bond ladder allows you to see when that cash will be available, so you can decide.  For example, you might be able to make it until June, when that first bond matures for $30,000.  And that might be enough to get you through.  In that case, you probably don’t need to sell anything.  And you might not need to have a huge savings account (earning hardly anything) if you have a bond ladder.  

Bond Ladder Benefit #3:  Smaller ‘Emergency Fund’ Requirements

When you can see the predictability of your bond ladder, how much money do you need to set aside in ‘cash?’   Probably not as much.  

And that’s part of the point.  Instead of an ‘all or none’ solution, where you’re faced with the choice of ‘being invested’ or ‘sitting in cash,’ a bond ladder allows you to do both.

And because more of your money is working for you in a predictable manner, you can set aside less of it in a ‘rainy day’ fund.  Which leads us to the next benefit—your portfolio is more stable.  

Bond Ladder Benefit #4:  Stability

No one really appreciates stability in their portfolio in an up market.  Certainly, in 2019, when the S&P 500 returned over 28%, very few people wanted the ‘stability’ related to a municipal bond that returned 1%.   Someone invested in a 50% stocks/50% bonds portfolio would have seen something around 14% in that timeframe.  Which isn’t a bad return (and certainly well above anyone’s idea of a sustainable investment return).  But when you see the market ‘outperforming’ your portfolio by such a drastic amount, it’s enough to make even the most patient investor question why they’re invested in bonds.

Of course, when the stock market is down 30%, then a client in a 50% stocks/50% is thinking, “Hey, I’ve only lost half as much as the rest of the market.”  Which is the exact point.  

Many of our clients are retired or approaching retirement.  While every portfolio could use the 28% returns (who wouldn’t want one of those years), very few of our clients would feel okay if their portfolio got cut by a third overnight.  

So you can’t have it both ways—if you’re going to take steps to reduce the risk in the down markets, then you’ve got to expect that the market will ‘outperform’ in the good years.   But while interest rates on bonds have been at historic lows, there’s no guarantee they’ll stay that way.  They might go up, which leads to the next benefit.   

Bond Ladder Benefit #5:  Protection Against Interest Rate Risk

So what happens if interest rates do go up?  If you’re not in a position to reinvest at higher interest rates, you could be stuck with a bunch of low-interest paying bonds or CDs for the duration of your portfolio.   Moreover, since the prices of bonds goes down when interest rates go up, that part of your portfolio could be worth less.  

So how does a bond ladder help in this regard?  

First, we revisit one of the key tenets of our bond ladders:  We hold everything until maturity.  If your CD is backed by the federal government, or your bond is expected to mature, we don’t care what the trading value is.  The reason is because as you get closer to the maturity date, the closer the value of your bond or CD will get to its maturity value.   In other words, a bond that has fallen in value will creep back up, and a bond that has risen in value will creep down.

Second, when that bond or CD matures, we simply reinvest at the (now) higher interest rate.  

Finally, we revisit benefit number 1:  We care about safety, not yield.  In other words, rising interest rates means that the interest income might go up, but that’s not the important part.  The important part is that the bond or CD is safe, either through federal backing (when available), or by holding out for very highly-rated municipal bonds.  

Conclusion

Our clients truly appreciate bond ladders in the down markets because they represent relative safety.   More importantly, our clients can manage their day-to-day lives because they know that money will be there to support their needs, when they need it.  And they don’t have to sell stocks in a down market to access it.  

If you’d like to know how a bond ladder might work in your portfolio, please contact us.  We would be more than happy to schedule a complimentary phone call to see how we might be able to serve you.  


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