These days, the best incoming investing strategy might have nothing to do with equities.
In fact, I’m practically shouting from the rooftops about a strategy known as a zero-coupon U.S. Treasury bond ladder.
This strategy is a mouthful, but it may be worth the jargon. IT involves buying a series of zero-coupon Treasury bonds with different maturity dates. The “ladder” of different maturity dates creates an income stream and lowers interest rate risk.
The idea is to have money coming due every year. Sort of like an annual or quarterly check. In my example, I am using zero-coupon U.S. Treasury securities. But bond ladders can also be created with bonds that pay coupon income.
In my case, I’m more interested in getting a fixed annual payout of maturing principal, and buying the bonds without income.
There’s a ton of flexibility to the ladder building process. And it is very personalized. But the general goals don’t change.
Set up an annual stream of cash flows over a period of time you choose, and in increments and dates you choose.
Use zero-coupon U.S. Treasury securities to limit credit risk to the ability of the U.S. government to pay you, its creditor, back when the bonds mature. Yes, I know there’s always a chance they won’t come through. But if that does occur, where else is your money safer?
For every $100 invested, the cost of buying those bonds, which are “discount” instruments, is less than $100. And they mature for $100.
Here’s what it looks like, using a graphic I created and used with my investment club members.
Graphic courtesy of Rob Isbitts for Barchart
I think of this as follows:
For every $100 I am investing, a portion of that will go to making sure I get the cash flow I want out of it. As you can see, it cost around $92,591 in this sample, to deliver $10,000 on May 15 of each year from 2030 to 2044. So I still have about 42% of my starting assets to deploy as I wish. But the $10,000 a year for 15 years is locked in.
I also created for my club members this plain-language guide, to walk them through it step by step. The yellow figure can be changed in the live sheet, to vary the amount of annual cash flow from bond maturities. The other figures can naturally be adjusted as well.
Graphic courtesy of Rob Isbitts for Barchart
This is really not about investing in bonds. It is about having a portion of my total portfolio that is set up with a long-term purpose. That purpose: predictability.
By having a set amount of capital maturing each year, I fix the return on a part of my portfolio. That could really help if the stock market cycles the way it tends to, reverting from years of double-digit gains to years of volatile-but-low returns.
The timeliness aspect is crystal clear to me, so I want to make it so for you as well, if this is something that interests you.
Interest rates are starting to show more signs of declining. So by locking in zero coupon Treasury rates in the current yield area, I’m getting near the highest rates in a very long time.
If rates fall hard, it could present a “high class problem.” The bond rates locked in will look very good at that point. But zero coupon bonds appreciate faster than coupon bonds, since they have no interest payment to mute the total return. It is all in the price. So that could result in a windfall profit situation.
On the other hand, if rates were to spike higher, that would hurt the price of the bonds. But it would only mean that the rates I locked in would be less competitive. The bonds will still mature when they are due.
This is very different from buying stocks and hoping they work out years later. History is littered with stocks of once-solid companies that lost money for shareholders for long periods of time.
This is not a stocks versus bonds thing. But it reminds us that the contractual nature of bonds (whereby the U.S. government owes you your principal at maturity), and the liquidity of zero coupon instruments, is a nice complement for stock-focused investors.
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Building bond ladders is a customized process. However, I am encouraged by the potential for capital appreciation from the zeros, should rates follow through to the downside.
The ETF shown above is a decent proxy, though its average maturity is longer than the ladder I presented. But take a look at what’s possible if rates dive, as they appear to be set up to do. This ETF doubled in price during 2019.
A bond ladder is not the first thing investors think about in this stock-obsessed environment. Maybe that should change soon. I know that for me, a semi-retired person with a desire for a portfolio “anchor,” a zero coupon ladder has been a game-changer.
I think this is a particularly timely “good to know” strategy for investors who are wary of the stock market and want an alternative to generate predictable cash flow. The key here is that the bond portfolio that spins out $10,000 a year for a total of $150,000 only takes about $92,000 to produce.
But I’m thinking “total portfolio, total return here.” So the rest of my assumed starting value of $150,000 in capital can now be managed more effectively, without a concern I’ll have all $150,000 at risk in the stock market. I think there’s a lot of peace of mind in that, especially these days.
Rob Isbitts, founder of Sungarden Investment Publishing, is a semi-retired chief investment officer, whose current research is found here at Barchart, as well as on Substack.
On the date of publication, Rob Isbitts did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. This article was originally published on Barchart.com
