Seeking Alpha
Research analyst, portfolio strategy, income investing, REITs
Profile| Send Message|
( followers)  

"Out of this nettle, danger, we pluck this flower, safety." - William Shakespeare

Regardless of interest rates, geopolitical turbulence or economic growth rates, bonds are generally a safe and reliable investment that income investors have historically favored.

Under the premise of The 4% Plan, which is to achieve a permanent income stream solution of 4% annually through simple investment strategies, an asset allocation of equities, bonds, commodities and cash is recommended for portfolio diversification and income safety.

The Asset Allocation

While equities make up a majority of the recommended portfolio distribution, bonds play a critical role. At a 15% weighting, bonds will ensure a portion of investment income while reducing the general risk of the portfolio.

Focusing On The First Goal - A 4% Annual Income Stream

As the goal of the investment portfolio is to earn 4% annually in the form of dividends, bonds will play a critical role. In simple math terms, a 4% yield on a $600,000 portfolio is 24k per year, or $2000 per month.

When investing in equities of well-run companies with stable dividends, there is always a dividend risk due to unforeseen circumstances. With the awareness of such risk, the investor should maintain an initial portfolio yield of over 4%.

Part 1: Creating A Target Portfolio Yield

An easy to manage goal for the portfolio is an overall yield range of 4.2% to 4.5%. This range would provide dividends between $25,200 and $27,000 per year, or $2,100 to $2,250 per month. In addition to the $2,000 per month the investor distributes as income, a cash cushion of $100 to $250 a month would be earned, thus increasing the cash balance by the end of the first year between $1,200 and $3,000.

(click to enlarge)

Another benefit of targeting a higher yield is to maintain a 2% cash balance. With zero portfolio growth, the balance would grow only if the yield grew at a rate above the 4% distribution level.

(click to enlarge)

In up markets, the non-cash portion of portfolio may grow at a rate higher than cash (especially at times of low interest rates). With asset valuations increasing, the cash level should increase accordingly to maintain the 2% level. Assuming the non-cash positions of the portfolio appreciate or depreciate 5% or 10% in the first year, the year-end percentage cash balance with the alternate portfolio yield targets would be as follows. Note that the 4.2% to 4.5% portfolio yield target will maintain a 2% or higher cash ratio in each example.

(click to enlarge)

As noted in the chart above, when the non-cash portion of the portfolio appreciates 10% on the year, the cash level would drop to 1.82% with a 4% portfolio yield.

If the non-cash portion of the portfolio was down 10% on the year, the 4.5% yield would create a higher cash level of 2.77%. This cushion of .77% over the desired cash rate could be reinvested with discount market pricing.

Part 2: Determining The Target Bond Allocation Yield

To review, there are four asset types in the portfolio. Of these four, only the equities and bonds will be producing reliable income. With hard-asset commodities such as silver and gold owned, that asset class is a hedge that produces no income. In a low interest rate environment, cash produces hardly any income as well. In this portfolio, cash is only a buffer to enforce the income stream.

When removing cash and commodities from the equation, the investor is left with equities and bonds to produce income. In aggregate, both positions equate to 92% of the portfolio (15% bonds plus 77% equities).

(click to enlarge)

As such, to discover the target yield average of bonds and equities with a 92% weighting, one must divide the total portfolio target yield by 92%.

(click to enlarge)

To summarize, a 4.2% to 4.5% total portfolio yield is desired for two reasons: to protect the distributions from dividend risk and to maintain a minimum of 2% cash. With a 92% bond and equity allocation, the aggregate bond and equity yield should fall between 4.57% and 4.89% to hit the 4.2% to 4.5% total portfolio yield range.

Building Up The Bond Portfolio

Within any general asset class, an investor reduces risk through diversification. Using funds rather than individual bonds, the investor is able to diversify between bond issuers, durations and investment ratings.

When targeting a bond fund, the key factors to keep in mind are management expenses, fund history, fund size, risk and return. With index funds the management fees should be low. Managed funds with higher risk will cost more to own, however the yield should be higher as well.

Part 1: The Three Types Of Bond Funds

Mutual funds offer a no-cost entry into bonds, while ETFs may carry an initial brokerage fee. Closed-end bond funds may be advantageous as they are not required to sell bonds when fund demand wanes, however these funds may also trade at a premium or discount to net asset value.

Part 2: Examples Of Bond Funds With Varying Yields

Below are several bond funds at various yields. With higher yield comes additional risk, however with the right bond mix the target yield achievement (4.57% minimum) is easily attained. Here are three bond fund examples, two of which are recommended at current levels.

1. Vanguard Short-Term Bond ETF (BSV), $80.53

Yield 1.13%

BSV is a $33 billion short-term government bond ETF that invests in 1 to 5-year U.S. treasuries. The dividend is distributed monthly and varies month to month. BSV has a forward yield of 1.13% and an expense ratio of .10%. This is one of the lowest-risk bond options available, however is not recommended as the yield is below the rate of inflation. BSV will be used as a tool of comparison versus other funds below.

2. iShares Investment Grade Corp Bond Fund ETF (LQD), $115.31

Yield 3.81%

This massive $17.2 billion ETF follows a U.S. dollar investment-grade corporate bond index. The dividend is distributed monthly and varies month to month, however the forward yield is 3.81%. This yield is 129 basis points over the 10-year treasury (2.52%). Also, with the rate of inflation expected to rise to 1.7% to 2% by 2016, this fund offers a yield that will beat inflation. As a passive index investment fund, LQD has a low management expense ratio of .15%.

3. PIMCO Corporate Opportunity Fund (PTY), $17.99

Yield 8.67%

PTY is a closed-end fund managed by Bill Gross. PTY normally invests 80% of funds in corporate debt, U.S. government debt, municipal bonds and asset-backed securities. It has limits of 10% to fund emerging market bonds and 25% to purchase non-dollar denominated securities. PTY has paid monthly dividends since 2003, has an expense ratio of .9% and as a closed-end fund, it may trade at a premium or discount. Today it trades at an 8.59% premium. For more details about PTY, please read the recent article "Searching For Yield With Bill Gross."

As noted in the chart below, U.S. short-term treasuries as measured by BSV carry very little risk. With that low risk comes a yield below inflation, such that the total investment return is negative. LQD offers a higher yield through a U.S. investment grade corporate bond index. With PTY, a higher income is achieved with leverage and exposure into other bond classes such as mortgage, high-yield and emerging market bonds.

(click to enlarge)

Part 3: Blending Bond Funds To Achieve The Desired Yield

While short-term treasuries are too safe and offer only a modest nominal return, funds ranging from investment-grade corporate debt to higher yield options do offer a real return. While the LQD is the lowest risk, the yield is paltry in comparison to higher yield options. With the desire to combine both safety and achieve higher yield, a blend of both fund types can create a balanced bond allocation to suit the needs of the income investor.

With the $600,000 investment portfolio example, a $90,000 bond allocation would be required for a 15% bond allocation. The following example is a blended bond fund investment of $90,000 that targets safety and a yield over 5%. Both the LQD and PTY funds are used with current pricing and forward annual yields.

(click to enlarge)

In this sample bond portfolio allocation, approximately 64% is weighted to the iShares Investment-Grade Corporate Bond ETF while 36% is weighted in the higher-yielding PIMCO Corporate Opportunity Fund. This sample leans toward the investment-grade bond index ETF to limit risk while granting exposure to a higher-yield fund to increase the total yield of the bond portfolio.

By investing in these two funds with a 64/36 split, the overall bond portfolio yield becomes 5.56%

(click to enlarge)

Conclusion

When building a portfolio designed for permanent income, bonds play a bodyguard-type role to maintain income distribution and lower overall risk. By creating a hybrid bond portfolio consisting of U.S. investment grade corporate bonds as well as other funds that offer a higher yield, a target yield rate above permanent income requirements can be achieved.

Over the long run the income investor benefits from diversified bond ownership. With the historical safety and high-demand for bonds, alongside many fund options that offer diversification, attractive monthly yield options and low ownership costs, investors can rest assured that this asset class will continue to deliver for years to come.

Source: The 4% Plan: Building Your Bond Position Now