Seeking Alpha
Richard Shaw, QVM Group (45 clicks)
Profile| Send Message| ()  

Matching the projected amount and timing of cash flow from an investment portfolio with projected cash flow needs is one of the tools that institutions and some individual investors use to reduce risk.

When bonds are selected to mature in certain amounts at certain times, that is typically called a “ladder.” While a ladder will not reduce the risk of interest rates rising and the bondholder consequently receiving below market interest income, a ladder does (presuming no default) remove the risk of having to sell the bonds at below par in a down bond market to raise cash to satisfy outlay requirements for operating or capital expenses.

Diversified bond holdings in each rung of the ladder are the risk management response to default risk, unless the ladder is built with Treasuries, which are generally viewed as default risk-free (until recently at least).

Institutions might tend to use credit bonds in their ladders for greater yield, but except for the very wealthy, the total capital required to cost effectively diversify a credit bond ladder is too high. Therefore, individuals would more often tend to build ladders with Treasuries.

The new BlackRock iShares end-date S&P AMT-Free Municipal Series ETFs are an alternative and potentially useful investment vehicle for matching cash flows with a ladder. They are a new product that we are monitoring for market adoption. The six funds mature in 2012, 2013, 2014, 2015, 2016 and 2017 in a ladder pattern.

Presumably, as one fund at the short end of the ladder matures and distributes its cash, BlackRock will add another fund at the long end.

You should read the fund fact sheets and prospectuses for a full picture, but basically each fund invests in AMT-free muni bonds that mature in the the end-date year (in the name of the fund). The fund pays monthly dividends and as the underlying bonds mature during the end-date year it holds the cash in a muni money market fund until all the bonds mature, then distributes all of the cash and then terminates. [see prospectus excerpt below and links to fund data sheets and prospectuses]

How Might These Funds Be Useful:

If you are still saving money and are many years from retirement or the need for cash from your portfolio, these funds or a bond ladder are generally not useful. However, if you are at the stage of life where you are currently drawing cash from your portfolio or have known future withdrawal dates in the next few years, these funds could be useful.

Consider the generic example of the person who is drawing $X per year from his or her portfolio to support their lifestyle. Assume also that that person will increase the draw by Y% per year to match increasing costs of living. Assume additionally that the person wants to “insulate” the portfolio from the risk of ruin that could develop if the portfolio value declines significantly for several years (because a fixed amount draw from a declining portfolio value becomes an increasing percentage draw each year).

That person might consider these three avenues among others:

(a) invest for maximum total return, apply whatever dividends and interest received to cash needs, and sell assets if necessary to obtain the the remaining cash needs — assumes substantial market risk and “risk of ruin” (risk of ultimately outliving assets).

(b) investing conservatively for income sufficient to meet the withdrawal needs — assumes dividend continuity risk to the extent that stock dividends are involved (not a bad bet with quality stocks, but 2008 would have seen both dividends and portfolio value fall).

(c) hold $X in a money market fund, own (1+Y) times $X in bonds maturing in one year, (1+Y)^2 times $X in bonds maturing in two years, (1+Y)^3 times $X in bonds maturing in 3 years, and so on for as many years as the investor wants to match scheduled cash flow from bond maturities with projected cash flow needs (allows the investor to “wait out” the market cycle with respect to withdrawals, and in some ways to take a longer-term approach — still have risk of ruin if $X is too large a percentage of the original portfolio value, but that is a topic for a different discussion).

The BlackRock iShares end-date muni fund series begins with 2012 (corresponding to “maturing in two years” in example (c). That gap could be handled several ways as of today, but by the beginning of 2011, there will be no gap.

In example (c), the investor would use the money market fund as the operating account to payout cash as needed during year one. As the money market fund is depleted, the short end rung of the bond ladder matures to refill the money market fund. The investor then buys a new ladder rung at the long end to keep the ladder at the same length on an ongoing basis.

To minimize the risk of having to sell assets at an adverse time, the entire portfolio would be structured to generate, to the extent possible, sufficient interest and dividend income to pay for the purchase of the new ladder rung at the long end. That gives the investor the opportunity to manage around fluctuations in portfolio income with respect to purchase of the new long end rung, rather than with respect to bills to be paid in the next twelve months.

The BlackRock iShares series allows the investor to incrementally accumulate the new long end rung with periodic portfolio investment income as received throughout each year, unlike individual bond purchases which may pose difficult minimum size hurdles for accumulation.

This example (c) is the kind of situation that we see as most likely to be the use for the new BlackRock iShares end-date muni ETFs. Treasuries are fine in principal, but in the current market, muni bonds pay more after-tax interest, and depending on your view of the credit risks, may be a better investment. Because of the credit risk, you need diversification that a product like the BlackRock funds provides.

We don’t currently own any of these new funds (inception January 2010), but find them interesting enough to monitor closely as they are adopted by the market.

Matching is an important issue for mature portfolios.

Descriptive Excerpt for Prospectuses (just to get you started, but not finished with your own due diligence):

Investment Objective
The Fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the S&P AMT-Free Municipal Series [the maturity year unique to prospectus] Index (the “Underlying Index”). The Fund does not seek to return any predetermined amount at maturity.

Principle Investment Strategies

“The Underlying Index measures the performance of investment-grade U.S. municipal bonds maturing in 2017. As of October 8, 2009, there were 983 issues in the Underlying Index.

The Underlying Index includes municipal bonds primarily from issuers that are state or local governments or agencies (including the Commonwealth of Puerto Rico and U.S. territories such as the U.S. Virgin Islands and Guam) such that the interest on the bonds is exempt from U.S. federal income taxes and the federal alternative minimum tax (“AMT”) as determined by the sponsor of the Underlying Index (the “Index Provider”) in accordance with its methodology. Each bond must have a rating of at least BBB- by Standard & Poor’s, Baa3 by Moody’s Investors Service, Inc., or BBB- by Fitch Inc. and must have a minimum maturity par amount of $2 million to be eligible for inclusion in the Underlying Index. …. All bonds in the Underlying Index will mature between June 1 and August 31 of the year referenced in the name of the Underlying Index. When a bond matures in the Underlying Index, an amount representing its maturity value will be included in the Underlying Index throughout the remaining life of the Underlying Index, and any such amount will be assumed to earn a rate equal to the performance of the Standard & Poor’s Weekly High Grade Index, which consists of Moody’s Investment Grade-1 municipal tax- exempt notes that are not subject to AMT. By August 31, 2017, the Underlying Index is expected to consist entirely of cash carried in this manner. The Underlying Index is a market value weighted index and is rebalanced after the close on the last business day of each month. BFA uses a “passive” or indexing approach to try to achieve the Fund’s investment objective. … BFA uses a representative sampling indexing strategy to manage the Fund. “Representative sampling” is an indexing strategy that involves investing in a representative sample of securities that collectively has an investment profile similar to the Underlying Index. T… The Fund generally invests at least 80% of its assets in the securities of its Underlying Index, except during the last months of the Fund’s operations, as described below. The Fund may at times invest up to 20% of its assets in cash and cash equivalents …

In the last months of operation, as the bonds held by the Fund mature, the proceeds will not be reinvested in bonds but instead will be held in cash and cash equivalents, including without limitation AMT-free tax-exempt municipal notes, variable rate demand notes and obligations, tender option bonds and municipal commercial paper. These cash equivalents may not be included in the Underlying Index. On or about August 31, 2017, the Fund will wind up and terminate, and its net assets will be distributed to then-current shareholders.”

Caution: Read the Prospectus Each Fund Before Investing

The fund fact page for each fund is linked below, and on each fact page is a link to the related prospectus.

Disclosure: Compliance Disclosure: We do not currently own any funds discussed in this article. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. This report is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance. Do not rely solely on this research report when making an investment decision. Other factors may be important too. Consider seeking professional advice before implementing your portfolio ideas.

Source: Matching Cash Flow Needs with a Bond Ladder