Lift Your Income With A Barbell

by: John Gerard Lewis

A barbell approach can provide good income with less risk than using bond mutual funds exclusively.

A ladder of defined-maturity bond ETFs reduces interest-rate risk.

A counter-balancing high-yield component boosts the yield of the portfolio.

The portfolio that I manage aims to be true to its name: stable high-yield. It's a barbell approach, with high-yield securities on one end and lower-risk instruments on the other. The goal is to achieve a composite return that is higher than that provided by intermediate-term bond funds, but with less risk.

Intermediate-term funds come with significant rate risk. If the Fed were to raise rates, as it is expected to do (how long have we been saying that?), funds with average maturities of three to seven years will experience significant price declines. For example, the price of the Vanguard Intermediate Term Investment Grade Bond Fund (MUTF:VFICX) would theoretically decline by nearly 5.5% were rates to increase by 1%. Longer-term funds, by virtue of their higher duration coefficients, would decline even more.

VFICX yields 3.06% as of July 17. How might we exceed that return with less risk?

As a threshold matter, we should understand that the very reason bond funds are influenced by rate fluctuations is that they have nonexistent maturity dates. These funds are constantly buying and selling bonds of various maturities for their portfolios, and therefore there's no single maturity date on which an investor can be certain that his invested capital will be returned.

The tried and true method of avoiding rate risk, therefore, is to buy individual bonds and hold them to maturity. For example, if Bank of America (NYSE:BAC) issues a bond that matures in six years, who cares whether rates rise? With BofA's S&P rating of A- for maturities in that range, it's extremely likely that you're going to get every penny of your principle back at maturity. Of course, that near guarantee comes with a catch -- your return over those six years is going to be about 2.8%. That's less than the current return for the Vanguard fund, VFICX, discussed above.

But with a little creative portfolio construction, we can get an appreciably better return with less risk.

Let's start by laddering four defined-maturity high-yield bond funds, for 80% of our portfolio. The benefits of this approach are three: high yield, diversification -- to eliminate specific company risk -- and, most notably, a date-certain maturity that nearly eliminates interest-rate risk. We'll allocate 20% each to:

• Guggenheim BulletShares 2016 High Yield Corporate Bond ETF (NYSEARCA:BSJG) yields 3.37% and, as with all of these Guggenheim ETFs, matures on Dec. 31 of its particular year. It is selling (as of July 17) at just 0.20% above its net asset value, and at maturity the difference should be negligible.

• Guggenheim BulletShares 2017 High Yield Corporate Bond ETF (NYSEARCA:BSJH) yields 4.04% and is selling at 0.22% above NAV.

• Guggenheim BulletShares 2018 High Yield Corporate Bond ETF (NYSEARCA:BSJI) yields 4.74% and sells at a premium of 0.54% to NAV.

• Guggenheim BulletShares 2019 High Yield Corporate Bond ETF (NYSEARCA:BSJJ) yields 5.26% and sells at 0.43% above NAV.

(Each of these ETFs has an expense ratio of about 0.44%, so you should deduct that amount and the respective premium to NAV from the yield to calculate your net rate of return.)

Thus have we built a ladder of maturities that will allow us to reinvest at the long end when each rung on the shorter end matures.

And this bond ladder constitutes the higher-risk end of our investment barbell, right? Wrong. These defined-maturity ETFs actually comprise the more conservative component on the barbell. "But it's high yield!" you may protest. "How can that be conservative?" Answer: It's a diversified collection, and the default rate for high-yield bonds is expected to be 2.5%-3% this year, which is lower than the historical average of just over 4%. Further, the fixed-maturity dates of these ETFs mitigate our interest-rate risk.

The riskier end of the barbell (just 20%) would consist of 5% positions each in:

• Market Vectors Mortgage REIT Income ETF (NYSEARCA:MORT). Mortgage REITS have been knocked down, so their valuations have actually become attractive. MORT provides a broad exposure to the group. It yields about 9%.

• Annaly Capital Management (NYSE:NLY). This highly-liquid Mortgage REIT comprises 13% of the MORT portfolio above, but it's the blueblood of the sector and is worth owning separately with its 12.3% yield.

• BlackRock Taxable Municipal Bond Trust (NYSE:BBN). This closed-end fund, which since inception has held 80% of its portfolio in Build America bonds, just announced that it will further diversify into other high-yield, taxable municipal bonds, hence the recent name change. Still, it intends to remain largely invested in Build America bonds for the foreseeable future. It yields 7.9%

And a modest exposure to the stock market isn't imprudent for the risk portion of this strategy, especially if it involves a high dividend stock. For that purpose, we allot a 5% position to Vodafone (NASDAQ:VOD). It sports a 3.2% dividend yield and a quite reasonable price/earnings ratio of 10 that, according to analysts, would equate to 9 times earnings by the end of 2016.

The composite yield for this portfolio, that is diversified and has low interest-rate risk, is 6%. The portfolio that I manage doesn't precisely match this one, but the idea is the same.

Disclosure: I am/we are long BSJG, MORT, BBN, VOD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.