By now, we hope you realize how exposed bond-heavy portfolios are to rising interest rates and inflation.
If not please read my previous posting Singing The Big Bad Bond Blues”. In that article on the subject, I discuss a generalized approach that can be taken by risk-averse investors approaching or already in retirement.

But let’s give you a specific example, to make things clearer.

Ellen is a woman in her mid 60’s, in excellent health. She realizes – and hopes – to be able to live well into her 90’s. She a widower who owns her own home, without a mortgage, and lives a comfortable, if modest lifestyle. She has no immediate dependents, but would like to be able to leave an inheritance to one of her favorite nieces, who is disabled.

Ellen no longer works, and hopes she won’t ever have to. But she’s a bit concerned about outliving her savings. She has heard some people talk about the possibility of rampant inflation caused by the government printing so much money. She’s not sure that right, but she remembers the inflation of the 70’s. She would be horrified at the prospect of being a burden to any one of her brothers or sisters if her earnings could not keep up.

Many people might envy Ellen’s situation, She still has about $300000 in liquid monies for her retirement needs. Her expenses run her about $3000 a month, and and these are largely covered by social security payment of $1400 and an immediate annuity that pays her $1500 for as long as she lives.

Part of Ellen’s problem is that her risk tolerance is very low. Just before retiring she had managed to save close to $900,000, but then had to watch in dismay as that portfolio melted down by 30% in the 2008 market crash. Having taken a $300,000 hit and seeing nothing but chaos and panic around her, she decided to cut her losses and preserve what she could. She converted a variable annuity – sitting on deep losses – into an immediate annuity and put everything else into CD’s.

With that loss so fresh in mind, Ellen has never felt comfortable getting back into equity investments. She has watched ruefully as the equity markets recovered almost all of what they had had lost. But Ellen continues to be terrified that just when she finally decides the equity markets are “safe” again, that’s when they will plunge. As Ellen put it sardonically, “When it comes to investments, Murphy’s Law was created for me”.

So does Ellen have anything to worry about? It depends on what happens to inflation and what return she averages on her money. If inflation stays moderate, averaging 3% and her investments average 4%, Ellen is in great shape. If she lives to the age of 105, she’ll still have over $1.6 million to leave to her niece.

But if inflation climbs to a 7% average, and her investments only average 4%, she’ll deplete her savings at age 95, as shown in the graph below.

Since Ellen’s own mother lived to age 96, Ellen is not happy with the prospect of outliving her money. She realizes she could probably sell her house at that time, but that is really not a prospect she likes. Nor would she be able to help her niece.

We’ve shown previously that a traditional investment in bond funds or bond etf’s will not protect Ellen’s portfolio in the case of rising inflation. If interest rates rise steadily over the next decade, the rate of decline in her fund’s principal could more than offset its returns.

Strange as it may seem, this does not rule out a bond ladder. By structuring the bonds within the ladder so bonds mature on a regular basis, and never selling a bond prior to maturity, principal declines due to interest rate increases are avoided. This is because bonds always mature at their original issue value on their date of expiration, regardless of how much they may have risen or fallen on the secondary market prior to maturity. (see image below)

The trick with a bond ladder is to stagger maturities in such a way as to always have a bond coming due at a time you might need the money, but also so as to be able to roll over maturing bonds into new bonds at higher rates of interest. The following images show the how this works in practice. (Click on images to expand them.)

Until recently, one of the disadvantages of bond ladders was their lack of diversification. By holding few bonds, bond ladders carry the risk that a default or partial default of one of the bonds in the ladder could greatly impact overall investment returns. Also, creating bond ladders for smaller portfolios has always been a challenge, as individual bonds may require high minimum investments. In addition, small investors tend to get clobbered with high purchase fees, as no sellers are willing to sell very small allotments at a good price. All of these factors – concentrated company and sector risk, high trading costs and a lack of liquidity – combined to make ETF’S and mutual funds more attractive than bond ladders for individual investors.

Now, however, this issue has been solved by a new brand of ETF’s that is designed to mature at a specfic target date . Bonds in these ETF’s are never sold prior to maturity, and are selected to mature as close as possible to the target date. As such, their real returns tend to correlate very closely to those of an individual bond expiring at the same targeted expiration date. But unlike individual bonds, they can be purchased at very low cost through discount brokerages or a Registered Investment Advisor, and they provide a great reduction of risk through diversification.

New targeted date ETF’s are appearing daily, but a current list already covers a wide spectrum of dates, ranging from 1 year to 9 years, and a choice of sectors, including corporates, tax free municipals and high yield (junk) bonds.

So here’s a solution to Ellen’s quandary: how to invest her money safely yet protect herself from a possible rise in inflation, all the while avoiding the roller coaster ride of equities.

Of the $300,000 she has available, we place $30,000 aside for emergencies in a short term CD. Yes this will
gather pitiful pennies of interest that will severely lag inflation, but it will give Ellen the piece of mind that
she has quick access to a sizeable amount of money to cover medical expenses or accident costs in an emergency.
(Granted that a 1 year Bond ETF can be sold at a moment’s notice with little loss from interest rate increases. But people are comfortable and familiar with CD’s at the bank.)

The remainder of the money, $270,000 is split up as follows:

Amount ETF Maturity Monthly pymt / share price * premium / discount YTM
$30,000 12/31/2014 $0.035 $21.29 0.0035 1.89%
$40,000 12/31/2015 $0.025 $21.80 0.0025 2.30%
$50,000 12/31/2016 $0.039 $22.14 0.0039 2.89%
$70,000 12/31/2017 $0.0016 $22.32 0.0016 3.90%
$80,000 12/31/2018 $0.031 $20.63 0.0032 4.20%

(Readers interested in seeing the impact of purchasing the ETF at a time when the ETF is not trading at an average holding par value of 1.00 are invited to read Mathey Peterson’s Seeking Alpha article on this subject. Bottom line: if you hold it to maturity, you can exactly calculate your real internal rate of return on the ladder rung, regardless of secondary market supply and demand.)

In year 1, Ellen’s interest will rate will average 3.01%, providing her with ample income, $678 per month. Since inflation is currently running at 2%, she has a real positive income of 1.01%. She will probably not spend all of this income, so funds are allowed to accumulate in a money market. Whenever a particular ladder’s rung is trading at or below par, this money can be used to purchase new shares. In the worst case, this will be when the next rung of the ladder matures and a new ETF contract is begun.

How Ellen fares from then on depends on interest and inflation. Let’s take a hypothetical scenario in which
inflation rises by 1/2 percent a year and interest rates track this. (In real life, the correlation is close, but not perfect, and the change in interest rates tends to come in bursts, not in a smooth curve. )

In year 2 then, Ellen’s first bond ETF matures, and she has $30,000 to reinvest. The funds are reinvested in a seven year bond fund at its new higher paying rate of around 4.7% (4.2% previous + 0.5% increase) Presto, Ellen’s overall average rate of return has bumped up from 3.01% to 3.2% , or from $678 to $721 a month.

The same procedure can be repeated each year as each rung of the bond ladder matures. In this way, Ellen avoids the drop in bond principal values caused by the rise in interest rates, and renews her portfolio at ever-increasing rates of interest. Still assuming interest rates go up evenly by 1/2 percent a year, by the fifth year she will be earning 4.10% or $922 per month.

In Ellen’s case, this setup is sufficient to guarantee that she will not run out of money in her lifetime
and will have enough to leave a good inheritance to her niece. Importantly, she has not had to take on more risk than she feels comfortable with. If interest rates and inflation never go up, she’ll be in an even more enviable situation.
This is not the case with an equity investment. In a major, prolonged recession, equities can go down severely and stay down for two and three decade periods. This happened to the US in the period between the Great Depression and World War II, and more recently to Japan in the so-called “Lost Decade” – that in reality spanned two and a half decades.

At the same time, the solution is not a panacea. Ellen had the advantage of only needing to slow down the speed of decline on her bond portfolio viz-a-viz inflation. She did not need to grow her money faster than inflation.

It is important to note that our hypothetical results, quite apart from their other worldly assumption of smooth interest rate increases over time, still did not keep pace with inflation in our example. Look at year 5. Ellen has boosted her overall portfolio return to 4.10%. But we assumed inflation was increasing 1/2 percent a year. This means that by year 5 inflation would be running at 4.5% (2% + (0.5% x 5)), and her real after inflation earnings, at -0.4%, would have turned slightly negative. The faster the inflation increase, the more this disparity would grow.

This is because, historically, there is a lag between the onset of inflation and public and private responses to the inflation that cause interest rates to rise.

Ultimately, to protect the investor against the ravages of inflation, the investor will need to put at least a toe-hold into the equities market. There are several ways to do so without completely exposing an investor’s portfolio to large downside risk, such as variable annuities, index-linked insurance products and CD-backed structured products.

One approach we’ve found particularly intriguing is that of combining a bond ladder with with a risk-reduced options strategy. The idea here is to take a portion of the client’s bond income, leaving principal untouched, and invest that in options strategies that limit risk to the amount invested. (Nota bene: many options strategies can cause an investor to lose a multiple of what they risk – we would strictly avoid such strategies.)

Certain options strategies (simple calls and puts, vertical and calendar spreads) allow a savvy investor or investment advisor to achieve risk – reward relationships that are disproportionally skewed in an investor’s favor. Unlike investing in stocks, where the risk – reward relationship is 1 to 1, a savvy options investor can structure investments in which the risk-reward relationship is 1 to 2, 1 to 3 or even, in rare cases , 1 to 20.

So if you can be right market calls just 50% of the time, and you spread your options plays over a dozen positions or so, such an options strategy can be very rewarding. Successful options strategists have concluded that they can double and even triple their money over a year’s period with a careful options strategy.

So imagine you have a bond ladder producing a safe 4% return, and you take half of that 2%, to invest it each year in such an options strategy at the end of the year. Starting in year 2 , doubling your money each year would turn that 2% into 4%. Reinvesting that the next year, plus the previous year’s earnings contribution of 2%, would produce 12% returns at the end of year 2. Assuming a doubling of results each year, by year

year porfolio share in options end of year options share Added bond earnings
0 0% 0% 2%
1 2% 4% 2%
2 6% 12% 2%
3 14% 28% 2%
4 30% 60% 2%
5 62% 124% 2%

As you can see, by risking only a fraction of their earnings, without a risk to the original principal,
such a strategy could double and investor’s entire portfolio within six years.

Of course, if the options investor had a bad year is say year 3, he could lose it all and have to start all over. But in the worst possible case, the investor fares very poorly in his options strategy and all monies invested in options are lost. He will not have risked his original capital principal, only a portion of his earnings.

So this strategy offers the upside of equities, but limits the downside. It effectively means: if I do well in my options trades, I can match the results I would get investing the bulk of my portfolio in equities. Yet if I do a poor job, I’ve only lost a portion of my bond income. My principal – though eroded by inflation – is intact, just as if I’d have left the entire amount in a low interest safe deposit account.

Let me be clear. Options investing is complicated. Most investors will be confused by them, and the learning curve is steep. It is easy to make mistakes, and these mistakes can be costly. I do not recommend that the average investor trade in options without consulting with an options expert who not only has an theoretical understanding of options, but years of hands on experience.

What I am saying is that in the right hands, options provide a powerful set of tools that when correctly applied, can greatly benefit even the very conservative investor who values safety and shuns risk.


Disclosure: The material presented on this site is for illustrative and educational purposes only. Investing in options involves risk of loss, and these losses can be substantial. Only risk capital should be used when trading options. We do not currently own any funds discussed in this article. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. This report is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance. Do not rely solely on this research report when making an investment decision. Other factors may be important too. Consider seeking professional advice before implementing your portfolio ideas.