Article
Strategies for Building a Laddered Retirement Portfolio
If the goal of saving for retirement is to provide financial
security, then a key objective of retirement portfolio management
should be generating a stable stream of income while preserving
investment principal. Bond laddering is a strategy that may address
both aspects of that key objective.
What Is Laddering?
A bond ladder is a portfolio of bonds with maturity dates that
are evenly staggered so that a constant proportion of the bonds can
be redeemed at par value each year. By holding bonds to maturity
rather than trying to buy and sell them in the secondary market,
investors may minimize the potential for losses caused by interest
rate volatility and market inefficiency. These losses and
transaction costs can be considerable.
Generally speaking, there are two broad types of bond ladders.
One can be implemented more or less perpetually for trusts,
endowments, and other applications with extended planning horizons.
Another form of bond ladder can be implemented for individuals
whose personal financial plans might have a definite end-point in
mind. Both types of ladders can potentially play a role in reducing
some bond market risks.
Perpetual Bond Laddering
This bond laddering strategy is most useful for an investor who
plans to conserve investment capital indefinitely and whose need
for cash flow is predicable. A typical ladder might be constructed
from Treasury bonds, with one-tenth of the portfolio being redeemed
and reinvested each year. As the following chart shows, such a
structure would have been significantly more productive and less
volatile over the past four decades than a strategy of simply
buying and rolling over short-term notes, such as three-month
Treasury bills. Keep in mind, however, that the long bond ladder is
significantly less liquid than a short bill portfolio. Virtually
all of the assets in the short portfolio can be liquidated at face
value within three months. In contrast, only 10% of the long
portfolio can be liquidated at face value in any given year; the
remaining 90% might be exposed to considerable market and interest
rate risk if it were sold in the secondary market rather than held
to maturity.
Comparing the Continuing Cash Yields of
Two $100,000 Investments |
|
Source: ChartSource®, SS&C Retirement
Solutions, LLC. For the period from January 1, 1993, through
December 31, 2022. Assumes a ladder of 10 years created in 1993,
where all bonds mature on December 31 of the given year, principal
amounts were rolled over into new 10-year bonds with then-current
market yields, and that interest payments were not reinvested.
Yields are based on yield data published by the Federal Reserve and
are imputed for maturities that the Federal Reserve does not report
(generally, 4-, 6-, 8-, and 9-year bonds). Using a bond ladder
strategy does not guarantee superior results. Index performance
does not reflect the effects of investing costs and taxes. Actual
results would vary from benchmarks and would likely have been
lower. Past performance is not a guarantee of future results.
© 2023 SS&C. Reproduction in whole or in part prohibited,
except by permission. All rights reserved. Not responsible for any
errors or omissions.
Laddering With a Fixed Term in Mind
Another type of bond ladder is one built to provide a steady
cash flow for a predetermined number of years. This can be done
with a zero-coupon bond, a type of bond that pays all of its
interest in one lump sum at maturity. Generally speaking, the
further in the future that one expects to receive the redemption
value, the less one needs to spend today for the bond.
Here is how the principal of a fixed-term bond ladder can be
applied to the needs of a retirement investor. In this hypothetical
example, the retirement portfolio is worth $250,000 at retirement
and the presumed withdrawal rate is 4% of assets per year, or
$10,000. Based on the interest rates that prevailed at the end of
2019, an investor could buy a series of 20 zero-coupon Treasury
bonds, one of which would become redeemable in each of the next 20
years. The total discounted cost of those 20 bonds would be
approximately $156,000. The balance of the original $250,000 could
be allocated to equities for growth potential, creating a portfolio
that still holds more than 30% equities. The core income of $10,000
would be stable, and the value of the equity portfolio should be
available to help augment income as needed to compensate for
inflation or provide extra latitude for spending. Equity value
could also be available to extend the term of the plan if needed.
Planning horizons of greater than 20 years can also be addressed at
the outset, albeit at somewhat greater cost. Note also that bonds
in the ladder will have value during the course of the plan, even
though their value may be subject to fluctuations caused by
interest rate volatility.
Investment Needed to Create
$10,000 Per Year |
Term |
Immediate total investment needed |
20 years |
$156,000 |
25 years |
$183,000 |
30 years |
$206,000 |
Source: SS&C Technologies, Inc. Indicated costs
assume the initial amounts are invested in zero-coupon U.S.
Treasury bonds maturing on the anniversary dates of the investment
and yielding the market rate for that maturity that prevailed on
December 31, 2019. Estimated investment needs for similar ladders
created on other dates will vary -- increasing as prevailing market
yields fall and decreasing as prevailing yields rise. This
hypothetical example does not account for potential custody
expenses, transaction costs, or tax liabilities, if any. The value
of Treasury bonds can be assured only when they are held to
maturity and redeemed by the U.S. government. Until redemption
time, the market value of Treasury securities varies as prevailing
interest rates rise and fall. Past performance is not a guarantee
of future results. |
Work With a Professional
An investment portfolio that has some of its assets allocated to
bonds may produce stronger cash flow with less volatility than a
portfolio allocated solely to equity investments such as common
stock shares. As such, a bond ladder offers investors a formula for
allocating their fixed-income holdings to potentially reduce the
unique risks of bond holdings and to achieve the results they seek
from their bond investments. Your financial professional can help
you determine whether bond laddering is an efficient solution for
your needs.
The Language of Bonds
- Par value is the face value of the bond (i.e.,
the value the bond was assigned when the issuer created it).
- Market value is the price for which a bond can
be bought or sold at any given time after it is issued and before
it is redeemed in the process known as secondary market trading.
The prices of bonds in the secondary market depend on the overall
level of interest rates. Prices of existing bonds rise when the
general level of interest rates falls, and prices fall when the
general level of interest rates rises. Individual bond prices can
rise relative to their peers in the secondary market if the
creditworthiness of the borrower improves, or they can lose ground
relatively if the creditworthiness of the borrower
deteriorates.
- Redemption value is the amount of money that
the issuer will return to the investor on the specified maturity
date. Redemption value is generally not affected by changes in the
secondary market price.
- Maturity date is the date set for repayment of
the bond's principal; it is normally established at the time the
bond is issued. A conventional bond is issued for
a fixed period. A callable bond can be redeemed at
the initiative of the issuer whenever the call conditions specified
in the bond are met. A putable bond can be
redeemed at the initiative of the investor whenever the specified
put conditions are met. A convertible bond is one
that can be exchanged for common stock at specified times.
- Coupon value is the cash amount of the
interest payment made to the investor each year. In most cases, the
coupon value never changes throughout the life of the bond,
regardless of any changes in secondary market value of the
bond.
- Coupon yield is the value of the interest
payment given to the investor each year expressed as a percentage
of the original par value of the bond. This figure does not change
during the life of the bond.
- Current yield is the value of a bond's
interest payment expressed as a percentage of its current trading
price in the secondary market. Current yield is actually the
primary basis for defining a bond's trading price in the secondary
market because current yields on existing bonds need to maintain
their relationships with market averages. To keep yields
synchronized with the market, trading prices are adjusted. Lowering
a bond's price has the effect of increasing its current yield
because the coupon payment would be divided into a smaller market
value. Increasing a bond's price has the effect of lowering the
current yield because the coupon payment would be divided into a
larger market value.