The Fool-Your-Friends Income Portfolio

by: John Gerard Lewis


Pundits have been saying that the Fed will hold interest rates down until sometime in 2015.

Keeping maturities short keeps your yield short too.

You can create a bond ladder using ETFs.

Well, which is it?

Many commentators have for months been saying that the Fed will hold interest rates down until sometime in 2015. Pimco's Bill Gross, principal exponent of the "New Normal" thesis (recently rechristened the "New Neutral") in June concurred that the Fed could begin raising rates next summer.

Forecasting another year of the easiest money ever seems reasonable enough, given that this half-step-forward/one-quarter-step-back economic "recovery" has yet to convince Janet Yellen that she can allow borrowing costs to increase. And we're all weary of predicting that "rates will be rising really, really soon, because, well, they just have to as the economy takes off. They just have to."

Well, they haven't because it hasn't.

In fact, it's not unreasonable to wonder if we'll be sitting here next summer again uttering our firm convictions that finally, absolutely, this time we're dead certain, rates will begin rising by mid-2016.

But declarations persist that The End is Near. Bank of America Merrill Lynch's David Woo sees the 10-year Treasury note leaping to as high as 3.5% by the end of the year. And Goldman Sachs' Abby Joseph Cohen fully expects it to do so.

For an investor, the question of how long rates remain at today's lows is not insignificant. Believing that there will be no change for a year or two prompts an investor to take more risk, perhaps lengthening bond maturities a bit to capture more yield while not, just yet, subjecting principal to rate risk. But if one subscribes to the thinking of Mr. Woo and Ms. Cohen, then by all means keeping maturities short is the thing to do.

Of course, keeping maturities short almost always keeps your yield short too, and that's no fun. There is a middle ground, though, that can be anticipated to protect principal while capturing more income.

Some people might think the ancient, tried-and-true technique of fixed-income laddering is boring, but I think any strategy that solves an investment problem is actually a lot of fun. You're outwitting the investment gods themselves. And if you're outwitting gods, then by definition you're being smarter than your fellow mere humans.

And with the following laddering strategy you can make all your friends think that you're taking outlandish risk when you really aren't. Why would they think that? Because you're investing solely in high-yield bond funds in a probable rising-rate environment. (Omigosh, Joe! Are you crazy?!)

But don't tell them this delicious secret: Your strategy is actually quite prudent.

Laddering substantially dilutes your rate risk. In fact, it's the single best solution for rate risk, as your money is spread over a series of maturity dates. As rates rise and your short-term bonds mature, you simply reinvest those proceeds at the long end.

And you don't hear much about this, but laddering spreads credit risk too: Because economic conditions change over time, any environment that might cause a higher number of bond defaults for one period of time is theoretically mitigated by better economic periods in which a portion of your bond holdings will mature.

In fact, let's look at that niggling credit risk more closely. Whether rates rise sooner or they rise later, the event is sure to be coincident with economic improvement, meaning that defaults would likely occur less frequently than they do now. And today's default rate for speculative-grade bonds is just 1.9%, according to Moody's. I'm not worried about credit risk in this laddering strategy.

Here it is: With Guggenheim Investments' line-up of fixed-maturity exchange-traded funds - the BulletShares High Yield Corporate Bond ETFs - you can assemble a portfolio that accounts for both rate and credit risk, while very likely maintaining positive purchasing power. The average yield of 3.98% for the following portfolio almost doubles today's inflation rate of 2.1%, and I would expect it to continue to beat inflation as conditions change over time.

2015 Maturity (NYSEARCA:BSJF): Yield = 3.43%*

2016 Maturity (NYSEARCA:BSJG): Yield = 3.76%*

2017 Maturity (NYSEARCA:BSJH): Yield = 3.90%*

2018 Maturity (NYSEARCA:BSJI): Yield = 4.35%*

2019 Maturity (NYSEARCA:BSJJ): Yield = 4.50%*

*Yields shown are based on annualizing the latest monthly distributions as of July 18, 2014.

The expense ratio for each of these ETFs is a very reasonable 0.42%, and all are trading within a fair range of net asset value.

Disclosure: The author is long BSJE, BSJF. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.