Wednesday, February 15, 2017

A Better Way to Build a Bond Ladder

Investors often gripe with what to do with the uninvested cash sitting in their brokerage accounts earning next to nothing interest rate while waiting for a market correction. I've been feeling the similar blues as I do have some cash from recent sales of a few overvalued stocks that I would like to reinvest.

However, the market is quite overvalued and it's hard to find bargains. Therefore, I would like to find a good place to park my cash while I wait for a bargain or a correction to show up.

So what are the choices for parking cash and earning some interest?



Banks hardly pay anything. My bank currently pays 0.03% interest on a money market savings account. An online only bank could pay up to a 1%, but I don' t like online only banks. Call me old fashion but I like to put my money in a bank or brokerage that has a physical brick & mortar presence so that I can go there and talk to someone if a need arise.



Also CDs (certificate of deposits) don't pay much either. You have to lock your money in a CD for several years to get 1-2% interest. I want the ability to pull out cash for investment as needed without having the cash tied into some long-term CD.

Another way to earn some interest on uninvested cash is by building a bond ladder. A bond ladder is built by investing in several individual bonds with different duration or maturity dates.

A bond is a debt (from issuer's perspective) and a fixed income (from investor's perspective) instrument and therefore it has a term duration and a maturity date.

An investor in a bond is essentially loaning money to the issuer (e.g. a corporation for a corporate bond) with the promise to get a certain percent in interest and the original principle amount back at the end of the bond term or maturity date.

That's the general idea behind investing in bonds, you earn a fixed amount of interest while your money gets used by the issuer of the bond and at the end of the term, you get your money back.

By combining multiple bonds with different or tiered maturity dates, you can essentially build a fixed income ladder that earns you interest while returning some amount of your principle back as each one of the tiered bonds mature. You will see an example of bond ladder later in this article.

Bonds are considered to be a safer investment than stocks, mainly because you are expected to get your original investment back at maturity. However, there are risks in investing in bonds.

Bond values fluctuate depending on the going interest rate and if you were to sell your bond prior to its maturity date, you could end up losing money if the bond has gone down in value.

The other risk with bonds has to do with the credit quality of the issuer. In the case of bankruptcy of the company that issued the bond, you may not get your money back. You also need to hold the bond for its duration to expect the full return of your invested amount.

Therefore, it is important to only invest in investment grade bonds from corporations that have a solid financial standing and business while understanding the implications of early withdrawal.

Buying individual bonds to build a bond ladder is a pain, especially if you want it to be well diversified. It could also be costly to buy individual bonds as one has to pay transaction cost per bond purchase and there are minimum purchase amount limits which can be as high as $1000.

As an alternative to individual bonds, I could buy a traditional Bond Fund or ETF (Exchange Traded Funds) that provides instant diversification and low cost of investment. The problem with such a fund is that it does not have a maturity date.

In other words, typical bond funds are open-ended funds with no maturity or termination date. Therefore, an investor in these traditional bond funds don't get the benefit of bond maturity and if the fund goes down in value, no matter how long you hold the fund, you can still end up losing money.

For these reasons, I have shied away from buying individual bonds or traditional bond funds for many years.

But now there is a new bond investment instrument that makes it easy and cost effective to invest in bonds while providing the benefit of bond maturity date.

While researching for ways to earn some interest on cash sitting in my brokerage account, I stumbled upon iShare's new iBONDs ETFs. These ETFs are from the same BlackRock company that also offers some of the most popular stock ETF funds. In fact, BlackRock is one of the largest ETF provider out there.

Below is some of my key findings from reading material from BlackRock on these new iShare iBOND target ETFs. My research below is not complete by any means; however, it should provide enough information to get you excited and interested in learning more about these new funds.

The Corporate iBOND ETF Advantage

  • Professionally managed with monthly re-balancing to account for rating downgrades and new issues.
  • Follows Blooberg Barclays Maturity Corporate Index.
  • Low cost with expense ratio of 0.10% (iShare iBOND ETFs).
  • Provides exposure to diversified investment grade corporate and municipal bonds.
  • Can be used to remain fully invested rather than having cash sitting in a brokerage account not earning any money.
  • Provides easy access to the bond market as the iBOND ETFs trade like a stock, so no dealing with over-the-counter purchases or sales.
  • Provides targeted yield over a 10-year duration; thus allowing for the investor to build a bond ladder using a few  iBOND ETFs.


Source: Barclays as of 9/15/16. Indexes shown correspond to the Barclays 2017, 2018, 2019, 2020, 2021, 2022, 2023, 2024, 2025, 2026 Maturity Corporate Indexes. Index yields are for illustrative purposes only.

Source: iShares iBONDS CORPORATE ETFs
The above chart shows an example of a iBOND ETF ladder spanning over 5 years with at least one ETF maturing each year.

What this means is that when an iBOND ETF fund reaches its maturity date (usually on or about December 31 of a given target year), the fund terminates and is liquidated. The liquidated funds are then distributed to the investors. This is similar to what happens with the individual Bonds, where upon maturity the investor is expected to get his/her principle amount. Note, I used the word 'expected' as there are always risks involved with all types of investments including bonds, and there is no guarantee that an investor will get all their money back at the end of the term. So, always read their prospectus or consult with a financial adviser to understand the risks involved before investing.

An investor can create an iBOND ladder using these ETFs in such a way that each year one of the funds will mature and the investor will get his money back (while earning interest all along).

So, if I wanted to invest $25,000 but afraid of investing in the stock market, I could spread out the $ 25,000 amount across the five iBOND ETFs in $5000 chunks with maturity or target dates ranging from 2017 - 2021. This will give me a monthly income with a yield spread ranging from 1.2% - 3.0% without the risk of stock market volatility while still access to the cash if I need it.

Note that bond values can move up and down as the interest rates change; however, if an investor holds a bond till its maturity date then they are expected to get their original investment amount back upon maturity. Same should be true for these iBOND maturity target ETFs and what makes them different from typical bond funds where there is no maturity date for the fund.

Components of Corporate iBOND ETFs primarily include iBONDs in consumer staples, energy, financials, industrial and utilities companies.

Source: Top Holdings in iShare iBonds(R) Dec 2017 Term Corporate ETF (Ticker: IBDJ)

Provides monthly income in the form of cash distribution. Below is the eight month distribution history for Dec 2017 Term Corporate ETF (Ticker: IBDJ):

Source: www.ishares.com

The charts below show exposure breakdowns by Sector, Maturity, and Credit Quality of the components in the iBonds Dec 2017 Term Corporate ETF.

Source: www.ishares.com

Source: www.ishares.com

Source: www.ishares.com
As you can see, the 2017 target iBond ETF is composed of a very well diversified set of bonds spread across multiple sectors with the maturity duration that matches the maturity of the ETF. Also, almost all of the iBonds within the ETF are of investment grade.

The fund charges 0.10% management fee which is very low and in par with most low cost index funds.

Source: www.ishares.com
Final Thoughts

These new iShare iBond ETFs seem to provide an easy and cheap way to invest in fixed income bonds while providing the best of both worlds (i.e. individual bonds and traditional bond funds).

As always when investing in any new strategy or an investment vehicle, I like to start slow and get familiar with the investment before committing large sums of money. Therefore, I will take small amount of cash and buy a few shares of the 1-year 2017 iBond ETF and run it through the end of the year to see how its distributions and final liquidation (ETF termination) works out.

If everything goes as expected then I can expand into building a long-term bond ladder using dfferent duration iBond ETFs with different maturity target dates. This strategy will provide me a decent interest on my uninvested cash while providing a gradually distributed liquidity to invest in stocks during correction/bargain times.

More information about these iShare iBONDs ETFs can be found at iShare's website here:  Build Better Bond Ladders

Disclaimer: I currently do not own any shares in the ETFs mentioned in this article nor do I have any affiliation with the companies mentioned in this article. 

Author of this article is not a licensed/registered financial or investment adviser and does not provide investment advice. This article is for informational purpose only. Full disclaimer can be read here: Full Disclaimer

2 comments:

  1. Thank you for this post. I found it very helpful.

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    1. You welcome and glad you found the article helpful :)

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