• Home
• About Myself
• Ask A Question
• Blog
• Disclaimer Statement
• Privacy Policy

Fixed Income Ladder Revisited

I wrote in an earlier post that people who are at the door step of retirement should fund the early years by setting up a fixed income ladder. Click here to read my previous post on this subject. In this earlier post I talked about how I use bank Certificate of Deposits (CDs) as the debt instrument to set up my 10-year income ladder. I got an enquiry from a reader saying his financial institution only offers CDs up to 5-year maturities. He was interested in setting up an 8-year CD ladder and wanted to know how to set up the last 3 years of the ladder.

I ran into this same problem because my credit union only offers CDs with maturities up to 7-years, I had to use another debt instrument to create the last 3 years of my 10-year income ladder. One option was to purchase individual bonds with the needed maturity dates. However, investing in individual bonds requires significant expertise that I do not have. Therefore, the instrument I use when CDs are not available is a short-term bond fund.

I do not own any intermediate or long-term bond funds. This is because the managers of these longer maturity bond funds often buy and sell many individual securities in the fund. This is a problem because buying and selling individual bonds means these funds have no set duration. This practice causes the value of these funds to go up or down on any given day. Therefore bond funds that invest in longer maturity bonds are more like an equity fund and cannot be used to create a fixed income ladder. If interest rates increased significantly from the current very low levels, a long-term bond fund’s price would drop significantly due to the longer average duration of the fund.

Duration is a measure of a bond’s sensitivity to changing interest rates. For example, if a bond or bond fund has a duration of 20 years, its price would fall 20% if market interest rates rose one full percentage point. Conversely, if market interest rates decreased one percentage point, a bond with a 20-year duration would increase 20% in value.

However short-term bond funds are different. Because the individual bonds are short maturity securities (usually less than 3 years), these funds hold their securities to maturity causing the fund’s unit price to remain more stable.

The actual short-term bond fund I use is a Vanguard Exchange-Traded Fund (ETF) (stock symbol: BSV). The BSV fund price’s 52-week low and high price is $80.59 and $81.94 which is less than a 2% variation in price. This small price fluctuation is due to changes in interest rates.

To illustrate the effect of market interest rate changes, let’s consider what would happen if someone needed $40,000 per year from his fixed income ladder. Let’s assume the last 4 years of the ladder is invested in the Vanguard exchange-traded fund BSV for a total of $160,000. The BSV fund has an average duration of 2.7 years. If market interest rates went up 3 full percentage points over the next few years, the BSV fund unit price would drop about 8% in value. Therefore, even short-term bond funds can drop in value if interest rates moved up significantly.

This means this person’s $160,000 invested in BSV would drop in value to about $148,000. This much drop in value is not good for a fixed income ladder. So how does one protect the value of a fixed income ladder where the assets are invested in a short-term bond fund? There are several ways to protect yourself against this drop in value. The approach I use is a hedge using an “Inverse ETF.”

An inverse ETF is an investment vehicle that inversely tracks an index. That is, when the index goes up in value the inverse ETF goes down in value and vice versa. It is similar to shorting an investment without the unlimited down side risk. Generally, I do not believe in shorting investments as they are short term vehicles that must be monitored closely. But the inverse ETF I use is for a specific purpose of protecting the value of my short-term bond funds against a general increase in market interest rates.

The ETF I use is the ProShares Ultra-Short 20+ Year Treasury fund (stock symbol: TBT). There are other inverse ETFs that one could use to hedge the interest rate risk of a short-term bond fund, but I use this one because it is highly liquid and it allows me to invest only a small amount of cash to create the hedge. The small amount of money needed for using TBT as a hedge is because TBT uses a long-term bond index (20+ years duration). Also the “Ultra-Short” term in its title indicates it is a double inverse ETF meaning it changes value at twice the rate of a normal inverse ETF. Let me provide an example of how this hedge can be deployed.

Let’s assume a retiree has invested $100,000 as part of his bond ladder invested in a short-term bond fund with an average duration of 3 years. This retiree decides to use the inverse ETF TBT as his interest rate hedge. The table below shows roughly how the short-term bond fund and the inverse ETF TBT would react to an increase in market interest rates.

As the table illustrates the market interest rates do not have to increase very much to significantly change the value of the TBT fund. This allows the investor using this inverse ETF to put up a lot less money than if he used a 1 to1 shorting vehicle with a shorter duration.

In the case of this retiree who is trying to protect the value of his short-term bond ladder, he would only have to invest about $4,000 in the TBT fund to protect his $100,000 short-term bond assets from a 4% increase in market interest rates. Alternatively, this retiree could have deployed a 1 to 1 inverse ETF with a 5-year duration to protect his short-term bond assets, but this type inverse ETF would require the retiree to invest about $10,000 to protect his assets from a 4% jump in market interest rates. This is a perfectly fine alternative approach. I just prefer to have less money tied up in hedges.

The TBT inverse ETF is not a perfect hedge. 2 to 1 short ETFs do not tract the underlying indexes as well as 1 to 1 short ETFs. Additionally, although unlikely, it is possible that short term market interest rates could increase while long-term interest rates do not. Also, inverse ETFs are constructed using derivatives which make them expensive. TBT’s expense ratio is 0.93% which is another reason I do not want a lot of money in these type vehicles.

Let me finish by clearly stating that I do not advocate anyone use inverse ETFs as a general investment bet on rising interest rates or any other market move. Inverse ETFs are volatile investment vehicles. I am only using this inverse ETF for a specific hedging purpose for my short-term bond fund assets. Also, I only have a small amount of money invested in this ETF.

There are other approaches to protect against interest rate risk, but this is the method I have chosen to protect the value of my short-term bond funds that make up the later years of my fixed income ladder.

Did you enjoy this post? Why not leave a comment below and continue the conversation, or subscribe to my feed and get articles like this delivered automatically to your feed reader.