Advisers look to safety ‘ladder’

As some financial advisers have watched client portfolios fall off a cliff in the recent market downturn, proponents of an unconventional allocation to low-yielding Treasury bonds are suddenly sitting pretty.

The basic laddered-bond allocation strategy, which is often mocked by critics for being too conservative, involves building a laddered portfolio over several years with long-term Treasury bonds that begin to mature upon a client’s first year of retirement.

There is no disputing that it is conservative, but in the midst of the market’s wild ride, the safety net feature speaks volumes.

The trade-off for holding one of the world’s safest investments is an annual yield of about 3% for a 30-year zero-coupon Treasury — and there are reasons to think that that yield could go even lower.

But yield is secondary to safety in a strategy that is designed to create a guaranteed retirement income stream, according to Bert Whitehead, a Franklin, Mich.-based financial adviser who started using the strategy for his clients 20 years ago.

“Up and down Wall Street, there are people trying to beat the market, but we’re trying to give market returns and peace of mind,” said Mr. Whitehead, president of Cambridge Connection Inc.

For advisers, a key element of the strategy is getting clients to accept the notion that safety trumps yield when it comes to the fixed-income portion of a retirement portfolio.

That point is often easier for clients to accept when they realize that the laddered-bond allocation is being offset by a more aggressive stock allocation that can represent up to 50% of the overall portfolio even after a client enters retirement.

“No matter when you buy them, the Treasury yields are always going to seem low,” Mr. Whitehead said. “Even back in the 1990s, when Treasuries were paying 7%, people didn’t like the idea of tying up their money in a government bond.”

Each rung of a 15-year bond ladder is represented by a U.S. government-backed bond that becomes predictable annual retirement income when sold at maturity.

Unlike a bond mutual fund, which offers no performance guarantee and can lose principal, a Treasury bond’s yield at maturity is guaranteed when it is purchased.

Critics of the strategy — even at a time when the stock market is down nearly 50% over the past year — charge that long-term Treasury yields in the 3% range are too conservative even to keep pace with inflation.

Some opponents also challenge the logic behind reinvesting the interest payments and holding to maturity a bond that is often used as a trading vehicle to take advantage of interest rate fluctuations.

“They’re using an instrument that’s designed to make a bet on interest rates, but they’re not betting on interest rates,” said Christopher Norwood, co-founder of Biechele Royce Advisors Inc., a Fishers, Ind.-based firm with $100 million under advisement.

“They should want the coupon cash flow so they can reinvest it to make more money for their clients,” he said. “To me, not taking the coupon payments and holding the bond to maturity is just lazy.”

Mr. Whitehead said that the bond ladder is a hedge against deflation, “providing the safety net that enables you to take more risk with stocks and real estate.”

Inflation, he explained, can “easily be hedged” with a long-term fixed-rate mortgage, cash, gold and real estate.

By design, the bond ladder will represent about 60% of a client’s portfolio in retirement.

When the market is in a down cycle, as it is right now, clients use the bond ladder as income.

In bull market cycles, the idea is to derive income from the stock portfolio and use the mature-bond rung to extend the ladder out an-other year or two.

Mr. Whitehead said the main reason more brokers and advisers don’t use Treasury bond ladders for their clients is because “brokers don’t make any money off them, and fee-based advisers can’t justify charging 1% on something with such a low yield.”

The ladders are built over time using a Treasury bond that was introduced in 1985, known as STRIPS, which is an acronym for separate trading of registered interest and principal securities.

This essentially means the interest generated is reinvested as opposed to being paid out annually or semiannually.

However, even though the interest is reinvested, it is still calculated as phantom income, which can create tax complications if the bonds are not held in a qualified retirement account.

The price of the bond will rise and fall in an inverse direction to interest rates, but the price at maturity does not change.

The bond ladder strategy “makes sense for investors who place a high probability on a protracted recession or a mini-Great Depression outcome,” said Andy Johnson, head of investment-grade fixed income at Neuberger Berman LLC in New York. The company manages about $160 billion in assets.

“Each of these outcomes would most likely lead to continued deflation to varying degrees,” Mr. Johnson said. “The flip side to this strategy is that the investor is locking in very low yields.”

Proponents of the strategy insist that the focus on yield misses the point that the bond ladder is designed as a retirement portfolio’s stable foundation.

“I explain this strategy to my clients, and I don’t know how much of it they understand, but nobody ever likes the yield,” said Sheryl Clark, who advises clients on a retainer basis as owner of Sunrise Financial Strategies LLC in Tucson, Ariz.

“The goal is to end up with 15 years’ worth of bonds equal to the amount of money my clients will need to live on,” she added. “You want to be locked in, and you want to know exactly what you’re going to get.”

E-mail Jeff Benjamin at [email protected].