One way to generate stable income and protect against rising interest rates is through a bond ladder, a strategy that can be done easily via ETFs that are designed for this purpose. Tim Plaehn, a leading income expert and MoneyShow.com contributor, explains the process, along with his recommended funds:
For the last decade, fixed income investments such as bonds or bank CDs have not been an attractive investment class. From 2008 until the present time, investing in bonds or bond funds kept your money almost completely idle. Those with capital to invest want to earn some sort of return from those investments and the bond market did not fill that goal.
With interest rates now creeping higher, I think it is time to again commit investment capital to the bond markets. First, let's look at the biggest negative of owning bonds. Rising interest rates cause bond prices to fall.
It's a strictly mechanical, mathematical effect and we are likely to be entering a period of increasing interest rates. If you own bonds, and rates go up, you will see your bond values fall. Yet, it's is not necessary to lose money when rates go up. That outcome can be avoided by simply holding them until they mature, when the full face value is paid off. This technique does not work with bond funds.
The fund share prices will go down with rising rates and will not recover unless rates decline. That's because a fund's portfolio is not fixed. Fund managers constantly buy and sell bonds at the current market prices and yields. As a result, bond funds can be terrible investments in a rising interest rate environment.
Buying individual bonds with the plan of holding the bonds to maturity avoids the bond fund dangers. However, for individual investors, it is a difficult task to build a bond portfolio. You will struggle to find bond dealers or brokers who want to work with individual investors. Also, once you own individual bonds (outside of Treasuries), it is nearly impossible to sell them without taking a serious haircut.
Even though you don't want to own bonds directly, I want to discuss the individual bond strategy of building a laddered bond portfolio. This involves spreading your bond investments across a range of maturities. Once established, the ladder operates more like a downward moving escalator where, as near-term bonds mature, the capital is reinvested into longer-term, higher-yield bonds. You have bonds maturing at face value at regular intervals.
Now let's discuss a real investment opportunity that will work in any directional interest rate environment. In April, Invesco acquired the BulletShares ETFs from Guggenheim Investments. Invesco then slashed the management fees on the investment grade bond ETFs. The BulletShares are corporate bond ETFs with fixed termination dates, when the bonds in each fund will mature and the proceeds paid out to investors.
Because these ETFs have a fixed termination, we can build bond portfolios that are laddered, low cost and diversified by holdings and lengths of maturity. The Invesco website has a page where you can put together your own bond ladder using these funds. Here is a five-year ladder that I put together using the investment grade ETFs:
- Invesco BulletShares 2019 Corporate Bond ETF (BSCJ)
- Invesco BulletShares 2020 Corporate Bond ETF (BSCK)
- Invesco BulletShares 2021 Corporate Bond ETF (BSCL)
- Invesco BulletShares 2022 Corporate Bond ETF (BSCM)
- Invesco BulletShares 2023 Corporate Bond ETF (BSCN)
With this five-year ladder, the blended yield-to-worst is 3.3%. Not bad, considering the amount of flexibility this strategy provides. To manage the ladder, as the nearest term ETF pays out, the proceeds would be invested in the next longer term ETF in the series.
For example, the 2019 Corporate Bond ETF will terminate at the end of 2019. When the returned principal shows up in your brokerage account, you would invest that money into Invesco BulletShares 2023 Corporate Bond ETF (BSCO) , which matures at the end of 2024, one year past the longest maturity when the ladder was established.
A laddered portfolio will increase its yield as rates increase without putting your principal at risk. The funds are easily marketable, so you can turn shares into cash if you need to. At this point in the business cycle, I recommend sticking with the investment grade ETFs. The risks in the high-yield side are not worth what you could earn.
Editor's Pick: This article was originally published on Real Money on Aug. 16.