Investing

Using bond maturity ladders to reduce sequencing risk

Last year I had the honour of presenting to an investor club in Melbourne for older Australians. Formed in the 1950s, some of the members were well into their 80s and 90s.  My talk was “Own your age in bonds”, a phrase coined by Vanguard founder John Bogle.

The 92 year old compere quipped afterwards that he had it wrong, and was 92% invested in equities.  Laughs all round, but it’s a common picture in Australia. It’s what you could call the retiree’s dilemma.  Australian investors have loved their equities for generations for good and ill.

Many retirees and other investors have the classic barbell of equities and cash, with nothing in between.  For many its 90% equities with some cash for rainy days.

While dividends are maintained then all’s well. But panic sets in when markets collapse and dividends are cut.  Think BHP two years ago and what might be for Telstra in the years ahead.

If clients don’t have sufficient rainy day cash, they’ll probably have to sell depressed equities to fund their living.  Rather than preserving capital, they’re spending it.  This is sequencing risk – the risk the timing and sequence of cash flows is hit by a downturn.  For clients in drawdown phase, this can cause damage they may not recover from.

Structuring your clients’ portfolios using both bonds and equities can help to manage this risk.

  • Equities for growth and
  • A bond maturity ladder portfolio to live off.

Corporate bonds generally yield more than TDs, so this split can provide better returns than equities plus cash.

Bond maturity ladder portfolios comprise of bonds that mature at regular intervals.  For example, a seven-year ladder portfolio will contain one bond maturing each year over the next 7 years.

Maturity Ladder portfolios can be beneficial to investors both in retirement and before retirement.

Your pre-retirement clients:
Using ladders as part of a savings portfolio

Client scenario:  Assume the portfolio you’ve constructed is already diversified across shares and bonds.  You like the yield of a specific seven-year bond, but you’re concerned about rate rises (where bond prices fall).  You know if they hold the bond to maturity there’s nothing to be worried about – your YTM would be locked in.  But seven years is a long time so it’s sensible to be concerned for longer-dated bonds.

This is where a maturity ladder portfolio becomes useful.  You develop a ladder of seven different bonds with one maturing each year. This reduces interest-rate risk, compared with investing everything in the seven-year bond. This is because bonds are more sensitive to rate increases the longer dated they are.

As bonds mature each year, you reinvest the capital in the next seven-year bond, and so on.  The ladder keeps rolling.  If there is a yield increase as you feared, it’ll have the least impact on the maturing bond.

In fact the bond matures at $100 irrespective of the yield increase.  You reinvest this in a new 7 year bond, which is now cheaper because yields increased.

This holds true even if yields increased significantly.  The par value of the maturing bond isn’t impacted and the new longer bonds are now cheaper. This provides your clients with the protection from the rate rise you feared.

In practice

In our 7-bond example, if yields rose 1% in a year, the unscathed capital from the maturing bond buys new 7-year bonds. Their duration of approximately 7 means they are about 7% cheaper (7*1%).

 

Your post-retirement clients:
Using ladders to provide income

For your retired clients, a bond ladder provides a stable way to provide predictable living expenses.

Client scenario:  Assume your view is equities will recover within 7 years of any major downturn.  You suggest a 7-year ladder with the rest in equities.  Your clients can live off the dividends, the bond coupons, plus the maturing bond capital.

Equities tumble 40% and dividends are cut.  Remember, we have corrections.  They’re real.  They happen.

Rather than panic selling equities to fund lifestyles – your client does nothing because they have seven years for equities to recover.  Their bond income and capital is locked in over the period.  Only a default will affect this and as you’ve selected investment grade issuers in the ASX 100 then the chances of a default are low.

In this example, your clients are consuming the bond’s capital as well as the income. To keep their ladder rolling, you could sell some of their equities to buy a new bond as each bond matures.  They still have equities to provide growth opportunities. But you’ve given them a stable bond ladder in the heart of their portfolio to fund lifestyles and help them to sleep at night.

You’re swapping part of their volatile equities for capital stable, 100% predictable investment grade corporate bonds.  Note this only works with holding bonds or XTBs directly.  The strategy does not work with ETFs or managed funds because they do not mature, and with the ever-changing nature of fund constituents, you also lose income predictability.

If equities take 4 years to recover, then your clients aren’t impacted. They will have the exact level of income you were able to tell them they would have, when you bought their bond ladder portfolio. You know that their coupons and capital are locked in, assuming that company doesn’t default.

You can help your clients achieve these outcomes using XTBs over investment grade corporate bonds on ASX.  View our Maturity Ladder Model Portfolio or talk to your Regional Manager on 1800 995 993 about a bespoke solution.

Richard Murphy, CEO & Co-Founder.

Maturity Ladder Model Portfolio

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