Post A CommentWe will continue to build upon the retirement income train of thought after recently discussing How to Generate Income From Your Retirement Investments. There are five considerations when building a laddered fixed income portfolio. As opposed to much of the information available out there, we are not here to sell you anything.
Therefore, we will walk you through the strategy of a laddered approach, the different products to choose from when creating a ladder, and their differences when it comes to flexibility. We’ll also address how to choose the term to maturity and the the importance of considering where we are in the economic cycle.
What’s the strategy?
As touched upon last week when we looked at Amy’s Results and How to Generate Income From Your Own Pension Plan, a laddered approach to the fixed income portion of your retirement is often recommended. The priorities for most people on a retirement income are three fold: to have guaranteed investments (both the capital invested and the yield), to get the highest interest rates possible and to have a stable income. While this is totally understandable, you should realize that these objectives are polar opposites.
This being said, a laddered approached can help you maximize yield while respecting the need for guarantees and income stability. A basic ladder is having 20% of the fixed income mature every year over the next five years. If your income needs change during the year you can adjust at the next maturity. If not, reinvest the capital for another five years, usually the highest rate (while ensuring Canadian deposit insurance coverage).
Products?
As discussed earlier, you are looking for investments that guarantee your capital and the yield. This narrows the choices available for your portfolio. Fixed income means that the amount of income generated by the product is fixed ahead of time.
Another important aspect of a product: who is guaranteeing the capital and return. It may also be helpful to review an article I wrote a while ago, Create a Fixed Income, Don’t Confuse Return with Revenue. The different products available are: term deposits (certificates of deposit and guaranteed investment certificates), bonds and treasury bills. You will notice I have not included ETFs, mutual funds nor preferred shares as we are looking for guaranteed capital and yield.
Flexibility?
It is important to determine your need for flexibility. I should stress the word: Need. Everyone wants flexibility. If you insist on it, you will reduce your return. Term deposits can be cashable/redeemable prior to their maturity dates. Often the rates are significantly lower (50% less at times) than certificates of deposit and guaranteed investment certificates that are not redeemable before the maturity date. On the other hand, treasury bills and bonds can be sold in a secondary market before the maturity date (see The Economic Cycle below for other risks involved).
Term to Maturity?
The number of maturity dates depends on the amount of your portfolio invested in fixed income products. This is because smaller investments have lower returns due to rates and commissions paid for bonds and t-bills. I have met numerous clients who would prefer to have 12-24 maturities, one every month for the year or two. As was the case for flexibility, few people really need this. Often, dividing your nest egg into five to ten portions makes sense. With investments of $50000 or more, it is possible to get bonified rates and commissions on bonds can be negotiated. If you have more than a million, look at bond terms over 5 years, after rates have gone back up (we are still looking at some of the lowest interest rates in history).
The Economic Cycle.
We have saved the most important news for last. Your ability to maximize the return/yield/interest rate is greatly affected by the economic cycle. It used to be a local thing but lately has been more affected by global events. So when you ask your advisor to find you a 5% term deposits and he answers with a nine year term to maturity, don’t be insulted. Thank the most recent bad news from around the planet. From the natural disasters in Japan, to the Greek sovereign debt or the unemployment closer to home in the USA, bad news creates a flight to safety. When more investors buy bonds, the price goes up.
As the prices go up, the yield goes down. Then to add insult to injury, once you have bought bonds, if the interest rates rise, the market value of your portfolio decreases. So, the lesson to remember, if rates are likely to rise (and remember: we are still looking at some of the lowest interest rates in history), be sure to hold your bonds to maturity. Yes, we said that bonds can be sold in a secondary market before the maturity date and the risk is they could be sold at a loss.
Next time out, we’ll look into the guarantee aspect of fixed income products. Let us know how you structure your fixed income ladder.
Author: Robert
