Thursday, February 9, 2012

What the Heck are Ladder Bonds?

What the heck are Ladder Bonds?  It is a scheme being touted by some folks as a way to make a lot of money with no risk.  Schemes rarely work - and usually are designed to separate you from your money.

I wrote before about Corporate Bonds.   They can be a good investment, or a horrible mistake, just like stocks - or anything else.  The higher the rate or return on a bond, the chances are, the lower the bond rating is.  What this means is that a lot of people have looked at the company's financials and thought, "Gee, this is a risky investment!  The company could go bankrupt!"

And when that happens, it may wipe out your bond investment - or return only a pitiful pennies on the dollar.  So when someone says that XYZ company is paying out 15% on its bonds, well, you have to think long and hard whether XYZ company will even exist in a few years.  Chances are, it won't - which is why the rate on the bonds is so high.

We went through this before in the 1980's - Michael Miliken and his Junk Bonds.   At first, everyone thought he was a genius for finding high rates of return in junk bonds - like finding a diamond in the rough.  And initially, people invested in these and the rates of return were great.  Then, the bottom fell out - the companies that had leveraged themselves with high-interest debt found it impossible to service that debt, went bankrupt, and took out the bondholders.  Very quickly, the price of junk bonds across the board tanked, which decreased the value of the portfolios of people who invested in these things.  Even bonds paying interest - not in default - decreased in value, as people got scared.

So bonds are not a guarantee, safe investment - at least not Corporate Bonds.  U.S. Treasuries and FDIC-insured CDs are a lot safer, but are paying a lot less - on the order of 4% or less for long-term, fractions of a percent for short-term.

Some bonds or CDs are callable which means if they are paying high rates, and the borrower can refinance, they may pay you back, and you might not get your yield.  For example, Goldman Sachs has a CD that is callable in July.  It should pay 3.2%.  But if they can refinance the note at a lower rate (highly likely) then come July, bond holders will get their money back, plus six month's interest, and then have to find a new vehicle to invest in.  High rates of return are not guaranteed in perpetuity, even if the company remains solvent!

Lately, people are touting Bond Ladders, as a vehicle for investment.  The idea behind the investment is this:  You invest in a series of bonds which will mature at different times - say in one year increments.    So, for example, you take $100,000, divide it up into $10,000 chunks, and invest each chunk in a bond having a different maturity date - of 1 year, 2 years, 3 years, etc.

The idea is, that every year, you have a guaranteed return on your investment, and like a fixed-term annuity, pays you in steady increments.

Is there anything wrong with this scenario?  Well, first of all, unless you are willing to risk everything on junk bonds, the rate of return is pretty piss-poor these days on bonds - on the order of fractional percentages for government-backed bonds, and only a few percentage points for AAAAA rated corporate bonds.

Higher rates of return are available on B and C rated bonds, but bear in mind that these ratings are not like the ratings on your tests in school.    C is basically the lowest rating - an "F- please see me after class" and not surprisingly, the people offering these bonds are very risky financial companies - solar energy producers, financial companies, and even the Mohegan Sun Casino - which is yielding a fantastic 177% rate of return.   An amazing buy, or does someone smarter than us know something about the gaming business and the particular finances of that Casino?

So bonds are a conundrum - if you want low risk, you are going to have low returns.  If you have high rates of return, you have very high risk.

But what about "Laddering"?  What about it?  Why is this different than just buying bonds?  Why buy something in a fixed scheme, as opposed to just buying it?  Well, like anything else, people like schemes, and there are folks out there who like to SELL schemes.  And just buying a bond doesn't sound so sexy as a scheme of "Laddering" does it?  I mean, it doesn't have a catchy name, right?

You can open an account with eTrade, Ameritrade, Fidelity, and any one of a number of investment firms and buy bonds online.  You can go to and buy anything from savings bonds to treasury bills.  It is not hard to do.  Some of these "Ladder" sites suggest that buying a bond is some byzantine process that only highly trained scientists can do.  "Today, anyone can buy a bond!" they gush, as if it were rocket science, before.

The thing about bonds is, they are traded, just like stocks.  And just like stocks, they go up and down in value.  This seems a little non-intuitive at first.  If a bond has a $10,000 face value and pays out 5% interest over 10 years, why would it be worth less than $10,000 at any given time?  And the answer is simple: The value of the bond varies depending on the security of the underlying company (or government) issuing it, as well as prevailing interest rates.  5% today is a good rate.  But if prevailing rates go up to 10%, well, there are better things you could do with your money - so the value would go down.

And there is a good chance you may wish to sell a bond before its maturity date, particularly long-term bonds.  You buy a 30-year treasury bill, chances are, you will sell that before 30 years are up.  I know I would - I'd be dead before it matures!  And there is a secondary market for bonds, and they are traded - just like stocks.  But often, if you want to sell a bond, before its maturity date, you may take a hit on its value.

What prompted this posting was a reader who wrote asking about "Ladder Bonds" - and quite frankly, I had never heard of this scheme.  He was proposing to put all of his money into a Ladder Bond setup, so it would pay out, over time, a guaranteed amount.  I am not sure it is such a swell idea from two perspectives.  First, putting everything in one basket is never a smart move.   Second, either the rate of return is going to suck, or if you get a good rate of return, the risk factor will be very high.

Putting everything you have into one investment is usually never a very good idea.  Even if invested in "safe" U.S. Treasury securities, a ladder bond scheme like this would pay out very little, in terms of income, over time.  Short-term treasuries are paying less than 1%, and even longer-term treasuries are paying only a few percentage points in interest.

For a 70-year-old who has earned all the money they will have in life, and just wants a place to "park" cash that is safe, maybe a short-term t-bill is not a bad bet.  But for a younger person who has years to go before retirement, such a low rate of return could be wiped out by inflation, over time.

And if they try to increase yield by going to higher interest rate Corporate Bonds?  Their principle could be wiped out if the company goes bust.

Some sites say you can ameliorate this risk by investing in different companies and industries, so that no one chunk of your money is in one place.  So, for example, you divide you money into 10 parts and invest in 10 different Corporate Bonds that mature over different periods of time.  If one company goes bust, you "only" lose 10% of your portfolio.  However, that 10% could negate the earnings of the rest of the portfolio of bonds.  And if you are investing in high-risk, high-yield bonds, the odds of more than one company going bust are pretty high.  When the junk bond business went bust in the 1980's, the value of all junk bonds went down.

Schemes rarely work.  And yet people like schemes - they want the "one trick to the tiny belly" or the "secret to getting out of debt!" or "how to make a million dollars in the stock market!"   People want complex things, like our budget deficit, boiled down to simple terms - "Get rid of the Mexicans!" - as if such simple one-size-fits-all solutions will work.

I think a better approach is Diversification - to invest in a panoply of things, such that if one goes South, the others will still be there.  And over time, to make your investments more conservative, so by the time you retire, you have enough money set aside to live on, without having to rely on risky returns from stocks and bonds.

So yea, corporate bonds are not a bad part of a portfolio, but I would not put all my money there. And similarly, government bonds are not a bad part of a portfolio, but parking all your money there could be a horrible mistake, as it will not grow at all.  Mutual funds are fine, but putting all your money into one fund that you don't understand (or understand the fees and loads involved) is likely to be a mistake.  Real Estate is a good investment, but then again, investing everything in Real Estate is not a good idea either.

And while bonds might make a good part of a portfolio, I am not sure why arranging them in a "Ladder" structure is such a keen idea - as opposed to just buying bonds.

And there are alternatives to Bond Laddering Schemes as well.  For example, a CD (Certificate of Deposit) can yield a higher rate, in the short-term, than a Treasury Bill can do over 30 years.  And since they are FDIC insured, they are pretty secure.   For example, I had a WaMu CD that paid a pretty high rate of return.  WaMu went belly up, but since the CD was FDIC insured, I didn't lose a cent.  CDs can be bought at your local bank and have varying terms, and can also be traded online through your brokerage account.

But check out FDIC insurance limits - usually they are limited to $250,000 per insured bank.

Another alternative is an Annuity, which pays out a regular amount, for a fixed term, or the rest of your life (term and life annuities, respectively).  There are downsides to these, as they are not liquid, and are basically a contract with a life insurance company.  If the company goes bust, well, you might be insured through the State, or not.  Be sure to check before buying an annuity.  And let me tell you up front that the annuity salesman will simply pooh-pooh such concerns.  A friend of mine put ALL their money into an annuity.  I am not sure that is such a smart deal.   And there have been cases of fraud in this business - people selling annuities that don't pay out for 10, 20, or even 30 years, and selling them to 70-year-olds!

A Bond Fund is a mutual fund that buys and sells bonds.  Usually these have lower rates of return than stock funds, but are considered "safer."  Safer but not entirely safe, of course.   Bond funds trade bonds, and if they make poor trading decisions, a bond fund can go down in value - or fail to appreciate as much as inflation.

There is no 100% safe way to invest, it seems!  And that is why I think diversification is a good idea.

A bond ladder scheme is not a horribly bad idea.  I am just not convinced it is a panacea for investors.

UPDATE:  Yields on corporate bonds are so low these days - even on junk bonds! - that "investing" in them makes little sense.  Yes, I own a few corporate bonds, but it is not a main part of my portfolio.  Frankly, I get a better rate of return on a Capital One money market account than on any bonds, particularly government bonds, these days.