Optimal bond ladder structure?

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strathglass
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Optimal bond ladder structure?

Post by strathglass » 11 Mar 2008 22:48

I realize in all my readings I've never seen a satisfactory explanation of all the issues that go into constructing a "good" bond ladder.
Ergo I'm looking for some informed opinions on how to build a good bond ladder, and specifically would like to know more regarding:
  1. Optimal length? I've seen 5 and 10 years mentioned most commonly. However I haven't seen any convincing arguments on any particular length.
  2. Optimal time between maturities? For a 5 year duration, people usually talk about yearly durations (i.e. a bond is coming to maturity every year). But for other lengths (such as 10 years), I've seen people suggest yearly and others suggest every two years. It sounds like if you use a yearly approach you are minimizing the possible fluctuations (up or down). This would suggest yearly would be more appropriate given the general purpose of a bond ladder as a conservative holding within an investment account (RRSP for example).
  3. Constituent bonds? If you stick with the safest Government of Canada bonds you trade some yield for safety. How low a credit rating would you go? I have no problem going with provincial bonds, but beyond that I don't know enough to know if corporate bonds are too risky or not. One book suggested some institutions invest only in BBB or better rated corporate bonds. Is this satisfactory? How much research must you do to be sure (and how do you do this research)? (FWIW, I use TDW, although I'm not sure what research info they have for corporate stocks & bonds.)
  4. Bell: On a related note re corporate bonds, I've heard the bond holders suing Bell lost: I only read the end of the lengthy Bell thread. As someone who hasn't heard all the details, what I would like to know is this: what is the impact exactly of this Bell buyout on the bond holders? Are they loosing everything or only loosing some part of their bond value? And how do I as a bond investor avoid a similar fate if I am investing in corporate bonds? (IE as a corporate bond investor, could I reasonably have avoided [or expected!] the losses the Bell bond holders now appear to be facing, as the judge in the Bell case seemed to imply?)
Thanks,
strathglass.

I.LoveStripBonds
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Post by I.LoveStripBonds » 12 Mar 2008 08:00

I offer the following..

1) Duration of Ladder - Up To 5 Years as that is the average economic cycle - 10 years could be done - but I have never seen enough "premium" being provided to hold longer bonds
2) Roll over 1/5 each year and replace on the ladder
3) Positions - I use feds, provincials, municipals and quasi-gov't like the GTAA and a few solid corporates. Could use only GICS if wanted

The bond ladder is a great tool (I love it - note my handle)

Most folks don't ever know about it - they use bond funds instead

Regards
I.LoveStripBonds

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Re: Optimal bond ladder structure?

Post by marty123 » 12 Mar 2008 09:32

strathglass wrote:what is the impact exactly of this Bell buyout on the bond holders? Are they loosing everything or only loosing some part of their bond value?
In a nutshell, Bell bonds are debentures. They are unsecured. The buyout would result in new bonds being issued, and Teachers pledging Bell assets to provide guarantees to the new bondholders (i.e. funds used for the buyout will be a step above you in the pecking order if Bell fails). That resulted in market value of the Bell bonds to go down, commensurating with the risk. The court case was about preventing this from happening (by asking Teachers to buyout bondholders too) and it failed.

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Post by strathglass » 12 Mar 2008 21:02

I.LoveStripBonds - thanks for the feedback. Your statements align with what I was thinking, so that is comforting.

marty123 - thanks for explaining the Bell bond issue.

-strathglass

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Post by like_to_retire » 12 Mar 2008 23:14

I've seen people suggest yearly and others suggest every two years
Two years would be tricky once forced RRIF withdrawal kicks in.

With yearly maturities, it's fairly simple to keep aside the RRIF percentage after the bond matures that year before repurchase of the new bond. With two years it would be tough..

ltr

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Post by Bylo Selhi » 13 Mar 2008 08:23

like_to_retire wrote:Two years would be tricky once forced RRIF withdrawal kicks in.
If you have a ladder of GICs in an RRIF at BNS, they will redeem as much of the lowest-coupon GIC as is necessary to meet your minimum annual withdrawal requirements. There is no penalty for this. Perhaps the other banks do likewise.
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Post by adrian2 » 13 Mar 2008 08:30

Bylo Selhi wrote:
like_to_retire wrote:Two years would be tricky once forced RRIF withdrawal kicks in.
If you have a ladder of GICs in an RRIF at BNS, they will redeem as much of the lowest-coupon GIC as is necessary to meet your minimum annual withdrawal requirements. There is no penalty for this. Perhaps the other banks do likewise.
Don't forget you can take the withdrawal in kind.
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Post by strathglass » 13 Mar 2008 15:30

Good points about yearly maturities being helpful when it comes to RRIF mandatory minimum withdrawals (although that is 25+ years away for me!).

However if adrian2 is right and you can withdraw in kind, then it becomes a non-issue! (However I stil like yearly maturations in a 5 year cycle).

-strathglass

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Post by adrian2 » 13 Mar 2008 17:39

strathglass wrote:However if adrian2 is right and you can withdraw in kind, then it becomes a non-issue!
You definitely can - same idea as contributing in-kind.
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Post by like_to_retire » 13 Mar 2008 18:42

Don't forget you can take the withdrawal in kind.
I don't really see the advantage? Would I not be moving a bond that doesn't mature for two years out of my RSP so that it now throws off its higher taxed interest in an open account? I still have to wait two years until it matures to get any money from it? If I move securities into the RSP for the exchange, they may not be at an optimum sell time to get cash out for the RRIF requirements. I figure it's just easier to buy bonds that mature every year.

Can you explain the advantage.

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Post by AltaRed » 13 Mar 2008 19:16

like_to_retire wrote:I figure it's just easier to buy bonds that mature every year.
Amen...

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Post by adrian2 » 13 Mar 2008 19:22

like_to_retire wrote:Can you explain the advantage.
It's just another option, good especially when you're forced to do it but don't need the money immediately.
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Post by Shakespeare » 13 Mar 2008 22:59

Why would you move bonds out? You would use this to shift equities when you had to make a withdrawal and didn't need the money.
“A wise man should be prepared to abandon his baggage at any time.” -- R.A. Heinlein, The Door Into Summer.

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Post by like_to_retire » 14 Mar 2008 10:36

Why would you move bonds out?
I have nothing but bonds in my RSP. I would think that would be the case for quite a few people who had (small RSP/large open) situations.

I even have a rather large bond ladder in my open account because I have no room in the RSP to satisfy my overall allocation choice that includes 47% bonds.

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Post by dakota » 20 Mar 2008 07:16

I have a GIC ladder and withdraw 10k a year from my RRSP If I withdrew two 5k GIC's that had one year to run would the bank calculate the accumulated int. for the four years and add the amount to the 10k?

If not I would start putting the one 5k GIC into the TFSA and let it mature for one more year without being hit for the income tax of the five years
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Post by strathglass » 20 Mar 2008 07:58

dakota - I don't think you can do that. You can't get at the money until maturity (interest payments excluded of course).
-strathglass

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Post by dakota » 20 Mar 2008 08:41

I tranferred into the RRSP "in kind" why can't I withdraw "in kind"? Have you tried it?

Just called TDW and I can transfer a GIC out of my RRSP in kind but they will calculate the interest first and add it on to my withdrawal so what I had in mind will not work, end of story :(
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Post by strathglass » 20 Mar 2008 09:01

Yes, if you meant withdraw in kind that should be OK, I thought you meant access to the cash to spend!
-strathglass

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Post by Peculiar_Investor » 22 Jun 2009 08:20

There were a couple of threads that this could have gone under, but this one seemed the most on-topic.

I'm currently in the midst of a major review of our investment policy statement, specifically the asset allocation portion for fixed income. I foresee significantly increasing the allocation to fixed income over the next 5 years as we get closer to age 50 and for capital preservation reasons. We are still in savings mode and regularly putting aside excess funds into our investment portfolio (both registered and non-registered). We don't foresee the need to receive income from the fixed income portion of the portfolio for a number of years, which has led to the strategy of putting all fixed income investments into our registered accounts.

I’m well versed in stock analysis and stock picking but don’t profess any current skills in the fixed income area and therefore have tended to utilize ETFs (XBB and XCB) for fill the fixed income mandate for the portfolio. The current holding of our fixed income portfolio is an almost 50:50 split between XBB and XCB. The XCB holding was purchased earlier this year in an effort to capture the “disconnect” in spreads between corporate bonds and government issues. With the run-up in price of XCB and the narrowing of spreads as we return to a more “normal” credit condition, I’ve been waffling on whether it is time to sell the XCB and put the proceeds back into XBB.

I’ve been reading through various topics and threads on FWF to educate myself and have also read Hank Cunningham’s book, “In Your Best Interest”.

Key questions:

1) Construct a bond ladder vs. use bond ETF? As we don’t need to match specific income needs from the fixed income portfolio it would appear that using a bond ETF may be a better choice. IMHO the tradeoff is paying an ongoing MER versus the benefit of professional management and the pricing advantage that they enjoy.
2) If constructing a bond ladder, the general consensus appears to be to setup a 5 year ladder. If so, what are the initial steps to create the ladder? Does it make sense to allocate funds to the 1 and 2 year maturities during initial purchasing, particularly in light of the very low rates available?
3) The size of our fixed income investments will be in the 6 figure range, which should give us some purchasing power benefits. Within a year nn maturity purchase, do people tend to purchase a single bond or split the funds across a number of issuers? What factor(s) is considered in making this choice?

Any and all comments, recommendations and/or guidelines that would increase my knowledge on fixed incoming investing would be much appreciated.
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Post by scomac » 22 Jun 2009 09:45

Peculiar_Investor wrote:• Construct a bond ladder vs. use bond ETF? As we don’t need to match specific income needs from the fixed income portfolio it would appear that using a bond ETF may be a better choice. IMHO the tradeoff is paying an ongoing MER versus the benefit of professional management and the pricing advantage that they enjoy.
As long as you are buying in reasonable volume, you can off-set the pricing disadvantage against the MER; $10K-$15K tranches are usually adequate. The biggest advantage of the ETF is diversification that can’t realistically be duplicated in a bond ladder. It’s a moot point if you’re sticking with gov’t issues, but it must be factored in when buying corporate bonds.

You can make a pretty good case for owning a ladder of provincials/agency debt in conjunction with a corporate bond ETF as providing you with the best of both worlds.
• If constructing a bond ladder, the general consensus appears to be to setup a 5 year ladder. If so, what are the initial steps to create the ladder? Does it make sense to allocate funds to the 1 and 2 year maturities during initial purchasing, particularly in light of the very low rates available?
That depends on whether you have a large lump sum to invest, or not. If you do, then you would divide the funds up amongst several maturities and build an instant ladder. If your funds become available over time, then you would build the ladder over time buying at the longer end of your ladder to take advantage of the additional yield that longer maturing bonds offer. Don’t feel compelled to buy an issue for each year in a ladder. Ladders can be spread out over longer terms by purchasing every other year. This is essentially what I have done with my RRSP where I have constructed a 15 year ladder with 8 issues. You’ll likely miss the peaks and the valleys of interest rate moves, but you will still be able to follow the general long term trend. Even with a wrung every year, there are no guarantees that you will be able to capture a short-term spike in rates. That will be entirely dependant upon having a bond maturing at that time.
• The size of our fixed income investments will be in the 6 figure range, which should give us some purchasing power benefits. Within a year nn maturity purchase, do people tend to purchase a single bond or split the funds across a number of issuers? What factor(s) is considered in making this choice?
That would be entirely dependant upon how much money you had to allocate to each maturity. Generally speaking, there aren’t going to be that many bonds available at a given maturity at a great price on any given day. I don’t see any particular advantage to having more than a single issue for one wrung of the ladder up to ~$25K. Beyond that, you could split it if you like. When you get into $100K per wrung or more, then you would most likely want to split it up, perhaps into multiple issues.
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Post by AltaRed » 22 Jun 2009 11:47

I agree with what Scomac said with maybe only a few nuances:

1) In the gov't bond arena (including crown corporations), I would buy individual issues (rather than ETF) if one can buy in the $20+ range for each maturity. I would seriously consider XCB ETF for corporate bonds but have not entered that arena.

2) My RRSP is based on a 5 year GIC ladder at the moment because I want to be on the short end of duration in anticipation of higher inflation 2-4 years out and GICs have been paying better than gov't bonds. IOW, I do not want to buy a 8 or 10 year bond right now. If I thought we were in a benign interest rate environment, I would probably move to a 7, 8 or 10 year ladder and thus utilize nominal bonds for that ladder. I have seen nothing that suggests there is a sufficient rate premium for longer term bonds for years.

3) I have a 6 figure RRSP and have only one issue per year of maturity. I see no need to spread it around in multiple issues.

The only thing I disagree with scomac on is I would have an issue filling each year of my 15 year bond ladder. Interest rates are not all that steady and having unnecessary gaps in maturities doesn't seem very 'averaging' to me.

Doug
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Post by Doug » 22 Jun 2009 21:35

The Bogleheads wiki has a good section on bonds vs. bond funds:

http://www.bogleheads.org/wiki/Individu ... _Bond_Fund

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Post by Peculiar_Investor » 23 Jun 2009 08:23

Scomac, AltaRed and Doug, thanks for the replies and link. Much food for thought. I'm feeling that with these bits of education I'm graduating from primary school to high school, with much to still be learned.

To answer a query raised, we have been raising cash recently through equity sales, so currently have the funds available to build out the whole ladder should we choose. We have the flexibility to wait for issues that are priced well. At this time we are not trying to match maturities to withdrawal needs, so having gaps in the maturities is not a problem.

We have currently holdings on XBB and XCB, but I'm inclined to head towards the DIY route so that in the future when I need to worry more about matching maturity to income need, I'll be better prepared on the ins and outs of purchasing individual bonds.
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