Building your Bond Portfolio From a bond fund to a laddered bond portfolio - by Richard Croft The Laddered Approach Structuring a Laddered Portfolio Margin Trading The goal for most professional bond mutual fund managers is to out-perform some fixed income benchmark, the most common being the Scotia Capital Universe Bond Index. The Scotia Capital Universe Bond Index is simply an index that measures a hypothetical portfolio of high-grade short-, medium- and long-term bonds. When looking at fixed income investments, there are two basic alternatives: 1) the domestic bond mutual fund and 2) a selection of individual bonds. With domestic bond mutual funds, the cards are stacked against the individual investor. How come? Timing is one example. There are lengthy delays after a reporting period, before the client can ascertain what the manager did or is contemplating to do. The astute investor in bond mutual funds will carefully review the quarterly (or semi-annual sometimes) statements when they are released eight or so weeks after the period-end. However, quarterly or semi-annual statements only provide a snapshot of where the portfolio has been. There is no way of telling whether the fund manager totally changed the structure of the mutual fund in the meantime. As well, there may be a new fund manager appointed with a different investment philosophy who could have made significant changes to the portfolio without your knowledge. One point to consider is whether stripped bonds are used. Strip bonds eliminate re-investment risk. On the other hand, the bid/ask spread for a strip bond can be quite large. That implies liquidity risk. Finally, what percentage is exposed to currency risk? Currency exposure can do wonders for a bond portfolio's bottom line. It can also cause significant losses should the manager fail to properly predict the ups and downs of the Canadian dollar. And then you have to ask what it is that you want from a bond fund: investment management expertise with the management of your bond portfolio, or a currency play? At the end of the day, most bond funds are destined to be average performers. No one gets it right all the time. And being wrong at any point in time can take years to recover from. So most bond managers accept the premise that you win by not losing. The Laddered Approach So, how do you choose from the myriad of bonds available with any hope of outperforming or even keeping pace with those high powered portfolio managers with their charts, databases and information? Surprisingly, it is not as difficult as you might imagine. Simply, keep in mind two basic principals: 1. There is no annual management fee when managing your own fixed income portfolio. 2. No one really knows where interest rates are going. It is possible to achieve consistent above-average performance in all types of markets through a passive portfolio management approach that, unfortunately, few managers utilize. This portfolio management approach is the "Laddered" or "Staggered Maturity" approach. Laddering simply means spacing the maturities in a fixed income portfolio, such as investing each 10% of your portfolio into 10 individual bonds and staggering the maturity dates of those 10 bonds, so that each bond matures annually for the next ten years. Then, when the first bond matures, it is re-invested into a new ten-year bond and so on. This approach can be used for taxable accounts using interest-bearing bonds or for RRSPs using stripped bonds. Essentially, it means that you always have bonds maturing in all market conditions. That allows you to smooth out income, thus ensuring decent revenue even when yields are low. A laddered portfolio will out-perform 75% of professional fund managers for the following reasons:
1. No interest rate guessing. Fund managers and market-timing clients fall behind the eight ball when they make a bad guess. 2. A laddered portfolio is always 100% invested, with short-, mid- and longer-term bonds always in the portfolio. This eliminates the risk of being in the wrong maturities at the wrong time of the cycle. 3. Since the portfolio is not being actively managed, there is no reason to hold Government of Canada bonds since they are the lowest-yielding bonds in the market. By investing in provincial government bonds, clients will earn an extra compounded return per annum, which adds up over time. Corporate bonds often yield a higher return as well. You can also actively manage the portfolio if you feel comfortable about predicting the direction of interest rates. If you fall into this camp, then a modified, laddered approach may have merit. In this case, a specified percentage of the portfolio -- say 50% to 75% -- is laddered with the balance actively managed. This article has been written by and is a publication of an independent third party (the "Third Party Content Provider") and not Scotia Capital Inc. or any affiliate of Scotia Capital Inc.. The Third Party Content Provider is not an employee of Scotia Capital Inc. or affiliated in any way with Scotia Capital Inc., and Scotia Capital Inc. neither endorses nor accepts any responsibility or liability for the content of any of the publications of the Third Party Content Provider displayed herein or otherwise. The display of these publications by Scotia itrade in connection with the Scotia itrade service are for information purposes only. Scotia itrade does not provide financial, legal, tax, or accounting advice, or advice regarding the suitability or profitability of any security or investment or any decision in respect thereof. No reliance may be placed on Scotia itrade for any such advice and Scotia Capital Inc. accepts no liability in respect of any such advice. Any information, data, opinions, or recommendations provided by the Third Party Content Provider or any other third party in this article are solely those of the Third Party Content Provider and not of Scotia Capital Inc. or its affiliates. No endorsement by Scotia Capital Inc. or any of its affiliates of any third party product, service, website or information is expressed or implied by any information, material or content contained in or referred to on the Scotia itrade web site. Scotia itrade is a division of Scotia Capital Inc
How to Structure a Laddered Portfolio Eliminate the re-investment risk - by Richard Croft The Laddered Approach Structuring a Laddered Portfolio Margin Trading By laddering, or staggering, the maturities in your bond portfolio, you solve two principal issues; 1) you no longer have to make a guess about where interest rates are going and 2) you reduce re-investment risk. To understand how laddering works, consider an example where you have $100,000 to invest in a bond portfolio. You decide to invest equal dollar amounts at regular intervals along the yield curve. For example, for $100,000, you could purchase ten bonds each with $10,000 face value, maturing annually for 10 consecutive years. Depending on the circumstances, ladders may be of different durations -- that is, of longer or shorter maturities. The average maturity of this portfolio is 6 years. More importantly, the maturities span the length of approximately 2 business cycles. As mentioned, this portfolio will likely outperform 75 percent of professional bond mutual fund managers because: 1) you are not paying annual management fees; 2) you hold no Government of Canada bonds and 3) you are not guessing which way interest rates are going. As one year passes and your first bond matures, you invest it in another ten-year bond that meets your standards, and you continue this cycle, as long as you want to hold domestic fixed income bonds. This approach means that you are never concentrated in one maturity. And that's important when a bond matures and has to be re-invested. There are variations on this theme, of course -- some prefer shorter term ladders, others longer term, some have maturities every second year, others at six month intervals. One can also invest a percentage in foreign pay securities should currency diversification be desirable. As well, some investors may wish to put, say, 75% of their portfolio into a laddered structure and actively manage the balance, investing it where they feel the maximum returns will be obtained. This approach is also important in RRSPs; even though the plan is sheltered, the same principles apply except that you would build a ladder of strips. Since strips can be rolled into a RRIF, there is no compelling need to concentrate maturities at retirement age. It's great to have an example, but let's use a younger example and more accurate numbers (ie, in their mid to late 30s, and the realistic value using strips vs. long-term maturities) This article has been written by and is a publication of an independent third party (the "Third Party Content Provider") and not Scotia Capital Inc. or any affiliate of Scotia Capital Inc.. The Third Party Content Provider is not an employee of Scotia Capital Inc. or affiliated in any way with Scotia Capital Inc., and Scotia Capital Inc. neither endorses nor accepts any responsibility or liability for the content of any of the publications of the Third Party Content Provider displayed herein or otherwise. The display of these publications by Scotia itrade in connection with the Scotia itrade service are for information purposes only. Scotia itrade does not provide financial, legal, tax, or accounting advice, or advice regarding the suitability or profitability of any security or investment or any decision in respect thereof. No reliance may be placed on Scotia itrade for any such advice and Scotia Capital Inc. accepts no liability in respect of any such advice. Any information, data, opinions, or recommendations provided by the Third Party Content Provider or any other third party in this article are solely those of the Third Party Content Provider and not of Scotia Capital Inc. or its affiliates. No endorsement by Scotia Capital Inc. or any of its affiliates of any third party product, service, website or information is expressed or implied by any information, material or content contained in or referred to on the Scotia itrade web site. Scotia itrade is a division of Scotia Capital Inc.
Trading Bonds on Margin by Richard Croft The Laddered Approach Structuring a Laddered Portfolio Margin Trading Investors typically gain experience in the markets by first investing in a few stocks. As more money is added to the portfolio, additional stocks are selected to benefit from diversification. (Alternatively, the investor chooses an equity mutual fund for the instant diversification it offers.) Somewhere down the line, the investor will venture into the less familiar world of bonds and debentures, again seeking the diversification offered by this different asset class, as well as the addition of a steady, fixed income to their portfolio. By including bonds in the portfolio, the world sometimes becomes instantly complicated. Familiar with products such as Canada Savings Bonds and Guaranteed Investment Certificates, which do not change in price with interest rate changes, the investor is often surprised and more than a little mystified that bonds and debentures do change in price, and that there is an art to forecasting interest rate changes and future bond prices. To properly diversify a portfolio, then, with some cash, fixed income securities and stocks, it seems the total portfolio value has to be $100,000 or more, well out of reach of many a small investor. Again, this is why many small investors resort to investing through mutual funds. But what if you want to make your own bond selections, perhaps to profit from an anticipated change in interest rates? Investing through a mutual fund will not give you the opportunity to choose your own bonds. The answer lies in what is called margin investing, where the investor can purchase a trading unit of bonds with money borrowed in large part from their brokerage firm. Buying bonds on margin uses the same principle as buying stocks in a margin account. You buy the securities, get a loan from your investment dealer to help pay for the purchase, and hope the securities go up in price. You then sell the securities, use the proceeds to pay off the loan, and any leftover balance is yours to keep. The idea is for you to make money using somebody else's money, in this case the brokerage firm's. That's what is called leverage. The difference with bonds is that the leverage is potentially much greater, because the loan values for bonds are significantly higher than those for stocks. For example, purchasing a stock on margin may mean that you can borrow 20%, 40% or 50% of the purchase price from your broker, depending on the stock, or even as much as 70% for certain high quality stocks. By contrast, a typical loan value for bonds is 90% or 95% of the purchase price. This latter loan value means that an investor could make a $100,000 purchase, borrow 95% of that purchase price from their brokerage firm, or $95,000, and put up only $5000 of his or her own money. A $100,000 bond position could therefore be added to a portfolio for a mere $5000. Adding a fixed income asset class to a portfolio is within reach of virtually every serious small investor. Before we explore this opportunity further, some attention needs to be paid to the lingo of margin investing, and to a few simple calculations of who puts up what percentage of the money. The first important term is the account balance required, which is based on the initial purchase price. For example, suppose an investor purchases $100,000 of a bond at par (or 100% of face value). The account balance required to pay for the purchase is $100,000. Note that this figure really has nothing to do with margin investing; the investor bought $100,000 worth of securities, and therefore needs $100,000 in their account to pay for them. The next bit of terminology is the loan value of the security. This is the percentage of the bond's current market value that the investment dealer can loan you towards your purchase. While the investment dealer would like to loan you the full purchase price, the regulators feel this is not healthy for the capitalization of the investment firm, and so they set limits on how much the dealer is allowed to loan the client. The maximum loan value on a typical corporate bond is 90%, so the investor can borrow, in this example, $90,000 of the $100,000 purchase price paid to the seller. The third important term is the margin requirement, which is the amount the client must put up. This is simply the difference between the purchase price ($100,000) and the current loan value ($90,000), or $10,000 in our example. In this case, then, the investor has added a diversifying $100,000 fixed income component to their portfolio with only $10,000 of their own money. Here's an inside tip on the proper use of this terminology: Many investors and even investment professionals mix up the terms 'margin rate' and 'loan value', speaking as if the margin rate is the amount they can borrow. This is incorrect; margin is the amount that they can't borrow. In the above scenario, for example, the margin rate is 10%, not 90%.
Here are some typical maximum loan values for various types of fixed income securities: Security Maximum Loan Value High-grade Corporate bonds 90% Goverment of Canada bonds 95% Provincial bonds 95% Government of Canada Strip bonds 85% A final term is the margin call. Sometimes the investor is required to post additional margin due to price changes in the market after the initial purchase. This extra margin is referred to as the margin call. Margin calls arise because of a peculiarity in the way the margin calculation works: the account balance required is based on the initial value of the transaction back at the time the bonds were purchased, while the maximum loan value is based on the current trading price of the bonds in the market, an amount that can change daily. To the extent that the current trading price has deviated from the initial purchase price, there will be a margin call (if the trading price has dropped below the purchase price) or excess margin (if the trading price has risen above the purchase price). When an investment dealer calls the investor for additional margin, the margin call must be met by the beginning of next day's business at the latest. Suppose, for example, that the bonds in our example have decreased in market value to $98,000. The account balance required is still $100,000, since it is based on the initial transaction. However, the loan value is 90% of the current trading value of $98,000, or $88,200. The margin requirement is now $11,800 ($100,000 minus $88,200). Since the investor has only posted $10,000 and the margin requirement is now $11,800, a margin call will go out to the investor for an additional $1,800 in funds, which must be deposited before the opening of business next day. Also note that the loan value is still 90%, but that the investor's responsibility or margin rate is now greater than 10%. That's because the two rates have different bases. Initial Transaction After Price Change Account Balance Required $100,000 $100,000 Less: Maximum Loan Value (90%) $90,000 $88,200 Equals: Margin Requirement $10,000 $11,800 Less: Client Deposit $10,000 $10,000 Equals: Margin Call $0 $1,800 Margin investing involves leverage, or investing a small amount to cover a proportionately much larger position. Essentially, this means buying something you can't really afford. And therein lies a major advantage, and disadvantage, to margin investing: it's great if the price of the underlying security rises, but not so wonderful if the price drops. If interest rates fall, for example, and the bonds rise in price to $110,000, the investor would have made a profit of $10,000 on an investment of $10,000, for a return of 100%. On the other hand, if the bonds dropped to $90,000, there would be a 100% loss. That's what leverage does: it enhances profits, but it also enhances losses. Good if the bonds rise in price, and bad if they fall. Besides the double-edged sword of leverage, what are some of the other benefits and pitfalls of using margin to invest? First of all, of course, there are the margin calls. Every day that the bond trades in the market, there is a possibility of another margin call. To avoid having to keep running into the brokerage firm every day with another cheque, investors typically deposit a treasury bill or other interest-bearing security to cover any potential margin calls. As long as the security on deposit exceeds the cumulative margin calls, there is no need to deposit additional funds. Another drawback to margin investing is the interest charged on the loan. The investment dealer often charges anywhere from prime plus one percent to prime plus three percent or more on these loans. To offset this somewhat, you are receiving interest payments from the bond being held, albeit only every six months. Therefore, interest charges could rack up for up to six months before you receive interest from the bond to help pay for it. Interest costs on margin loans are deductible for tax purposes against any investment income earned. Buying bonds on margin is one way to add a fixed income component to a portfolio. The inherent leverage can also be beneficial if the price of the underlying bonds goes in the proper direction. On the other hand, there are large risks to this technique as well, and therefore it should only be applied where the investor's objectives, preferences, constraints and risk tolerance make it suitable. It also helps, of course, to make the correct call on the future direction of interest rates This article has been written by and is a publication of an independent third party (the "Third Party Content Provider") and not Scotia Capital Inc. or any affiliate of Scotia Capital Inc.. The Third Party Content Provider is not an employee of Scotia Capital Inc. or affiliated in any way
with Scotia Capital Inc., and Scotia Capital Inc. neither endorses nor accepts any responsibility or liability for the content of any of the publications of the Third Party Content Provider displayed herein or otherwise. The display of these publications by Scotia itrade in connection with the Scotia itrade service are for information purposes only. Scotia itrade does not provide financial, legal, tax, or accounting advice, or advice regarding the suitability or profitability of any security or investment or any decision in respect thereof. No reliance may be placed on Scotia itrade for any such advice and Scotia Capital Inc. accepts no liability in respect of any such advice. Any information, data, opinions, or recommendations provided by the Third Party Content Provider or any other third party in this article are solely those of the Third Party Content Provider and not of Scotia Capital Inc. or its affiliates. No endorsement by Scotia Capital Inc. or any of its affiliates of any third party product, service, website or information is expressed or implied by any information, material or content contained in or referred to on the Scotia itrade web site. Scotia itrade is a division of Scotia Capital Inc.