Laddered Bond Portfolios

I received a call from a Dow Jones newspaper reporter yesterday asking me my thoughts on laddered bond portfolios as a strategy for income in retirement. She was under the impression that I was not in favor of them - possibly from something I'd written in the past (although she wasn't able to quite recall what she'd read and I wasn't able to quite recall what I might have written). Anyway, we had a very pleasant half hour conversation about laddered portfolios, fee-only versus fee-based (brokers) advisors, variable annuities, and properly diversified multi-asset portfolios...among other investment topics.

But I thought I ought to pass on my thoughts on laddered bond portfolios to my readers, since it was the primary reason she called.

I think a laddered bond strategy makes quite a bit of sense for retirees, but only as a part of a properly diversified multi-asset portfolio. I am not in favor of single asset portfolios for anyone, let alone a retiree. Putting your eggs all in one basket is never a good idea, even if it is in the supposedly safe basket of Treasury bonds, which I personally believe carry quite a bit of risk currently. (Bill Gross of Pimco is on the same page by the way as his firm - the largest bond investor in the world - is currently completely out of Treasury bonds according to statements the bond king has made in recent months).

Bonds were known as certificates of confiscation back in the early 1980s, before the great bond bull market kicked off in 1982. Bond investors had lost their shirts over the prior 15 years or so as interest rates had risen steadily along with inflation. Negative real rates eroded bond wealth steadily for better than a decade. However, Paul Volcker's Federal Reserve changed all of that by committing to sound monetary policy designed to bring down inflation and restore the stability of the dollar as a store of value. Bonds have proven a splendid investment ever since... until now.

It is highly likely that inflation will continue to rise and, with it, interest rates over the next decade. We may have another year or two to wait before the trend really gathers steam, but without drastic changes in U.S. monetary and fiscal policy, the odds of a long bond bear market are high. A laddered dollar bond portfolio is not where you want all of your assets in such an environment. Yes bonds will mature yearly and can be reinvested at higher rates, but the bonds in you portfolio will lose value. Any sales necessitated by unexpected cash needs will result in losses. And generating capital losses in bond investing is a cardinal sin. Even more dangerous is the strategy of attempting to "ladder" a bond mutual fund portfolio, given that bond mutual funds have a perpetual duration - duration is a measure of bond price sensitivity to changes in interest rates. The longer the duration the bigger the price moves in a bond, and perpetual is as long as you can get.

Far better to build a properly diversified multi-asset portfolio for our retiree that might include a laddered bond portfolio to go with the high-quality dividend paying blue chip stocks, the dollar diversifying international assets, and the inflation hedging tangible assets (real estate and commodities primarily).

The S&P 500 is rallying short term after moving into oversold territory, but is likely to at least retest the recent low at 1256. It is still too early to tell if the correction is merely the pause that refreshes on the start of a topping process that will ultimately lead to the next downleg in the ongoing secular bear market. We reiterate that fair value for the S&P 500 is in the 900 area and that the economy is now showing clear signs of slowing - a combination that would suggest prudence is the better part of valor at the moment.

Correction

The market is finally starting a correction that could eventually turn into a full fledged bear market, depending on what policy decisions the administration, the Federal Reserve, the ECB, and the Chinese make in response to a slowing economy in the U.S. and rising inflation overseas. The S&P 500 has lost 7.7% since its 2 May peak of 1370.58 (5.3% of that loss coming in June). The next key support is 1249 - the 16 March low. Selling pressures sufficient to take out the 1249 support level would sharply increase the likely of further significant downside testing. There is strong support for the S&P 500 from 1150 down to 1000 however, making the onset of a full blown bear market unlikely in the next few quarters. Tops take time to form and it is more likely that a bounce off of 1249, or perhaps off of 1220 support (10.9% pullback) will see the S&P 500 rally into year end and finish somewhere near the May 2 high of 1370.

Nevertheless, a renewal of the secular bear market this year can't be ruled out. S&P 500 fair value is in the 900 area, net profit margins are at record levels (and will certainly fall going forward), and the U.S. economy is showing signs of slowing. As well, the Chinese are tightening monetary policy and the ECB is talking about tightening monetary policy - both entities would like to deflect inflation away from their shores.

On the other side of the ledger is the President's desire to win re-election. It is very likely that Obama will take steps to bolster the economy short term (and by extension the stock market) in order to win re-election. No post WWII incumbent has won re-election with unemployment above 7.2%, which means Obama must do something fairly quickly to light a fire under the jobs market if he hopes to serve a second term.

Likewise, Ben Bernanke continues to send signals that QE2 will not be the end of his monetary largess. He apparently remains determined to use every monetary policy tool in his tool box to keep the stock market afloat while the banks continue to repair their shattered balance sheets. Bernanke is likely to trot out another initiative immediately on the heels of QE2's end on 30 June. Our forecast is still for a resumption of the bear market sometime in the next 12 to 18 months, but we continue to believe that we are more likely to feel the Bear's bite in 2012 than 2011.

We continue to look for high-quality dividend paying blue chips to buy. We also continue to invest in shorter duration fixed income investments, given the likelihood of rising interest rates in coming years. Finally we continue to invest in nondollar assets that will provide a hedge against purchasing power loss as the shortsighted policies pursued by politicians (on both sides of the aisle) and the Federal Reserve all but ensure rising inflation over the next decade.