Facing up to the income challenge #1: Bond laddering
There are lots of reasons why people invest money but for the vast majority of us it's about trying to build up a big enough pot of money to live on in the future. In practical terms that means turning our savings into an income stream.
This is no easy task given the very low interest rates on cash and government bonds at the moment. Handing your money over to an insurance company to buy an annuity (a guaranteed income for life) is unpopular for good reasons but at least you don't have to worry about running out of money.
The problem that most DIY investors are having to face up to is how to get more money than an annuity without taking so much risk with their money that they can't sleep at night.
Having the freedom to cash in your pension pot might be a good thing but for the uninformed it could be downright dangerous. Sadly, I think we will hear many stories in the years ahead of people who lost their pension pot through bad investments.
Over the next few weeks, I am going to be writing about how the private investor can try and tackle what I see as the income challenge - having enough money to retire and making sure the money doesn't run out.
I am going to be looking at generating an income with bonds, shares and funds in separate articles.
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The income challenge
According to the latest Hargreaves Lansdown best buy annuity tables someone with a £100,000 pension pot will get the following fixed income for life at these retirement ages:
- 55 years £4,741
- 60 years £5,181
- 65 years £5,852
Looking at this another way. At 55 it takes you just over 21 years to get your money back. At 60, it takes just over 19 years and at 65 it takes just over 17 years.
You can see why lots of people think this is a bad deal. But how are you going to do better than this? I think it is going to be very hard without taking some risks with your money.
That said, I am not totally down in the dumps about it. This is a complicated problem with lots of possible strategies to tackle it. In these series of articles, I am not going to get into the ins and outs of every possible solution. Armed with ShareScope and SharePad, I am going to introduce you to some ideas as to how to set up an income-producing portfolio.
This week I am going to show you how to do this using bonds.
This article does assume some basic knowledge about how bonds work. (For more on bonds click here.)
Building an income stream with bonds
Despite the higher levels of income that can come with some shares, the wild ups and downs of the stock market are just too uncomfortable for some people. Investing in bonds has always provided a way for those that don't like taking big risks but want a regular income.
That said, bonds are by no means a risk-free investment. There's always the possibility that the issuer of the bond won't be able to pay you the interest due and/or your money back. The price of bonds also change when interest rates change (they are like a seesaw and go up when rates fall and go down when rates rise). The possibility of rising interest rates in the future has seen an increasing number of investors shun bonds in recent times.
One of the most popular ways of reducing the interest rate risk of bonds whilst producing a regular and predictable source of income is called bond laddering.
What is bond laddering?
A bond ladder is a portfolio of bonds with different maturity dates. So for example, someone with £100,000 might split their bond portfolio evenly into five different parts (these are the rungs of the ladder) with maturities of two, four, six, eight and ten years.
This avoids the risk of buying one ten year bond and locking yourself into a fixed interest rate for a long period of time. Say you buy a ten year bond with an interest rate of 3% and then interest rates rise to 5%. You can't take advantage of these higher rates - apart from reinvesting the 3% interest you receive - because you are locked in until the bond matures. If you tried to by selling your bond you might end up losing a lot of money as the bond will have fallen in price to adjust to the higher rates of interest on offer elsewhere.
By having a bond ladder portfolio, you are able to take advantage of rising interest rates by having bonds mature at regular intervals - in this case every two years. So when the first two year bond matures, your longest maturity bond is now 8 years. To maintain the ten year ladder you need to invest in another bond with a ten year maturity. This will then boost the income of your bond portfolio as the interest rate will be higher.
If interest rates fall, you won't be reinvesting all your portfolio at once and so will be able to hang on to higher interest rates for a while.
As well as reducing the interest rate risk, bond laddering can help you set up a portfolio with regular and predictable cash flows, providing the issuer doesn't go bust of course. This is because the strategy is based on holding the bonds until they mature. The investor therefore knows how much interest and bond repayment (typically £100 per bond held) they will receive each year which makes it a handy way to plan your finances.
Remember this very important point: with an annuity you exchange your pension pot for a guaranteed income for the rest of your life. The point of a bond ladder is that you keep your pension pot and generate an income from it yourself. That is, you retain much or all of your pension pot to bequeath to your loved ones.
How to build a bond ladder using ShareScope or SharePad
- Decide how many years you want your ladder to last for. Generally speaking, the longer the time you invest for the more income you should receive as interest rates usually - but not always - increase over time.
- Determine the number of rungs on your ladder - how often you want your bonds to mature. This will give you the number of bonds in your portfolio. The more bonds you have, the more diversified your portfolio will be.
- What will your ladder be made of? You could just stick to government bonds or add corporate bonds or even fixed term savings accounts.
Putting a bond ladder together in practice is not as easy as it is in theory because it can be quite difficult to buy bonds with the exact maturities that you need. Using the example of a ten year ladder, with rungs of approximately every two years, I've put together a model portfolio with current UK corporate bonds and a government bond (gilt).
SharePad and ShareScope both include information on government and corporate bonds. We've just enhanced the bond data in SharePad so I'll be using this to illustrate the rest of the article. ShareScope users have some of this data and will get the upgrade soon.
So, I'm looking at the Retail bond list in SharePad. These are corporate bonds traded on the LSE's ORB exchange and which can be bought by private investors through their stockbroker. The list also includes a number of government bonds.
In SharePad, there is a bond setting provided which includes columns such as:
- Price
- Dirty price
- Maturity date
- Income yield
- Gross redemption yield
- Coupon
Double-click on the Maturity column heading to sort the list and you should get a list something like this:
Here are the bonds that I have chosen from the list to build a £100,000 portfolio. You will need to research the bonds before you buy. You can find out how to do this in my bond basics article (click here).
| Name | Price | Dirty price | Maturity | Income yield | Gross redemption yield (GRY) | Coupon |
|---|---|---|---|---|---|---|
| Unilever PLC 16/6/2017 4.750% | £106.75 | £107.15 | 16/06/2017 | 4.45 | 1.18 | 4.75 |
| Beazley PLC 5.375% NTS 25/9/19 | £104.60 | £106.27 | 25/09/2019 | 5.14 | 4.17 | 5.375 |
| 3 3/4% Treasury 2021 | £111.87 | £113.22 | 07/09/2021 | 3.36 | 1.74 | 3.75 |
| HSBC Bank PLC 07/07/2023 6.5% | £116.73 | £116.90 | 07/07/2023 | 5.59 | 4.06 | 6.5 |
| Vodafone Group PLC 04/12/2025 5.625% | £114.78 | £118.24 | 04/12/2025 | 4.92 | 3.91 | 5.625 |
As you can see, I've put together a very simple five bond portfolio starting in 2015 with bonds maturing roughly every 2 years until 2025. The life of the portfolio is currently just over ten years and will end in December 2025. This will then change as bonds mature.
So if you want to keep a ten year bond ladder, then when the Unilever bond matures in 2017 you will have to buy a bond that matures in 2027 - so ten years from 2017. The Beazley bond will then become the 2 year rung on the ladder and all the remaining bonds will have moved down two years as well.
As the main focus is on income, the bonds are selected on the basis of their income yield (the annual interest or coupon divided by the current price). In the portfolio above, the income yield ranges from 3.36% to 5.59%.
However, you must pay attention to the total return of the bond as well (its gross redemption yield) which takes into account the capital gain or loss you will receive when the par value per bond (usually £100) is paid back. It's all very well picking bonds that pay you an income but in the current bond market you will probably have to suffer a capital loss to do so. If you are going to set up a bond ladder then you need to work out how much of your capital you want to trade off in return for an income stream.
Costs and income of a bond ladder
Every bond ladder will cost different amounts to buy and have different flows of income. There are three amounts of cash that you need to focus on:
- The costs of buying the bonds
- The income paid over the life of the bond
- The money that you will get back when the bond matures
The cost of buying bonds
When you buy a bond from your broker you usually have to buy what is known as a nominal amount of bonds (based on its par or redemption value of usually £100). There will also be a minimum amount of the bond (known as a minimum denomination) that you can buy. For the Unilever bond above the minimum amount is £2,000 nominal (or 20 £100 par value individual bonds).
So how much will these cost?
Let's say I want to buy £20,000 worth of all the five bonds. SharePad is telling me that the price of the Unilever bond is £106.75, but that's not the price that I pay. That's because the seller of the bond is entitled to their share of the interest accrued since the last coupon was paid. This needs to be added to the £106.75 and is known as the dirty price. This means I pay £107.15 for each bond. So an investment of £20,000 in the Unilever bond (ignoring bid-offer spreads and broker commissions) will buy me the following number of bonds:
£20,000/1.0715 = 186.65
(rounded up to 187 bonds of £100) bonds or a nominal investment of £18,700
How much income will I get?
This is the amount of nominal investment (in this case £18,665) multiplied by the coupon rate. So for the Unilever bond this will be:
£18,665 x 4.75% = £886.58 per year
This income will be paid gross without any tax being deducted from it.
How much money will I get back when the bond matures?
With most bonds you will get back the nominal or par value of the bond. So in the case of the Unilever bond, I will get back £18,665 of nominal value. This means that I will lose money because it cost me £20,000 to invest in the first place. My loss is £1,337.
Remember if:
- The income yield is more than the gross redemption yield you will make a capital loss if you hold the bond until its maturity date.
- The income yield is less than the gross redemption yield you will make a capital gain if you hold the bond until its maturity date.
- The income yield is the same as the gross redemption yield there is no gain or loss if you hold the bond until its maturity date.
Is bond laddering a good idea given that bond markets look quite expensive?
If you hate the thought of having lots of your savings tied up in the stock market and want to have a lot of certainty of income then bond laddering is something that you might want to consider - at least for part of your portfolio.
But bond laddering does have some drawbacks. Let's look at the bond ladder I've created in a bit more detail.
| 10 year bond ladder | Nominal | Cost to Buy | Coupon (%) | Annual Income | Amount Paid back | Capital Loss on Maturity |
|---|---|---|---|---|---|---|
| Unilever PLC 16/6/2017 4.750% | £18,700 | £20,037 | 4.75 | £888 | £18,700 | £1,337 |
| Beazley PLC 5.375% NTS 25/9/19 | £18,800 | £19,979 | 5.375 | £1,011 | £18,800 | £1,179 |
| 3 3/4% Treasury 2021 | £17,700 | £20,040 | 3.75 | £664 | £17,700 | £2,340 |
| HSBC Bank PLC 07/07/2023 6.5% | £17,100 | £19,990 | 6.5 | £1,112 | £17,100 | £2,890 |
| Vodafone Group PLC 04/12/2025 5.625% | £16,900 | £19,983 | 5.625 | £951 | £16,900 | £3,083 |
| Portfolio Total | £89,200 | £100,028 | £4,625 | £89,200 | £10,828 |
So with this very simple bond ladder, I can get £4,625 of income per year until the Unilever bond matures in 2017 (providing all the companies and government behind the bonds are in good health). After that, I might get more or less depending on the level of interest rates and the prices of retail bonds. However, I have very little protection if the cost of living goes up over the next ten years as my income is fixed and will buy less.
That £4,625 is less than a 55 year old man will get with a £100,000 pension pot buying an annuity. He has given that £100,000 away but the bond ladder investor stands to lose £10,828 of their capital if they hold all five bonds to maturity.
For some, that might be a price worth paying for a secure income and a known loss. For others it might be a sign that the bond market is too expensive and that a bond ladder might have to wait until bonds get a bit cheaper and the potential losses come down.
So what would happen if interest rates went up by say 2%?
With something known as modified duration it is possible to estimate what would happen to bond prices if there was a 2% increase in interest rates or yields. I won't get into the calculation here but it would mean that your £100,000 savings pot would buy more bonds and more income with it. The income would increase by over £600 to £5,227 and there would be an overall capital gain of £195.
| 10 year bond ladder with 2% interest rate rise | Nominal | Cost to Buy | Coupon (%) | Annual Income | Amount Paid back | Capital Loss on Maturity |
|---|---|---|---|---|---|---|
| Unilever PLC 16/6/2017 4.750% | £19,400 | £20,017 | 4.75 | £922 | £19,400 | £617 |
| Beazley PLC 5.375% NTS 25/9/19 | £20,300 | £20,006 | 5.375 | £1,091 | £20,300 | -£294 |
| 3 3/4% Treasury 2021 | £19,800 | £19,990 | 3.75 | £743 | £19,800 | £190 |
| HSBC Bank PLC 07/07/2023 6.5% | £20,800 | £20,008 | 6.5 | £1,352 | £20,800 | -£792 |
| Vodafone Group PLC 04/12/2025 5.625% | £19,900 | £19,985 | 5.625 | £1,119 | £19,900 | £85 |
| Portfolio Total | £100,200 | £100,005 | £5,227 | £100,200 | -£195 |
That's about the same as a 60 year old man currently gets with an annuity with the benefit that you know you have a very good chance of getting all your money back as well.
Look out for the next article in this series on creating an income using shares.
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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.