Monday, 26 October 2015

Using Bond Ladders for Income

Using Bond Ladders for Income

Bond ladders are just one of many options for investors looking for predictable income. Like all these options, bond ladders have their advantages and disadvantages, but many investors decide to build a bond ladder because it can help manage the risks of changing interest rates and customise a stream of income, without ongoing management fees.

Building a bond ladder that diversifies across a number of bonds that mature at different intervals has the potential to decrease reinvestment risk. As yields and interest rates increase and decrease, a ladder may provide an advantage allowing you to adapt to changes with small parts of your portfolio instead of having to commit all of it at a single time.

Bond ladder considerations
While a bond ladder may help you to manage interest rate and reinvestment risk to some extent, there are six important guidelines to consider to make sure you are diversified, to protect yourself from undue credit risk or both.

1. Hold bonds until they reach maturity.
It’s important that you have enough money set aside to meet your short-term needs and deal with emergencies. Many of the benefits of bond ladders—such as an income plan and managing interest rate and credit risk—are based on the idea that you keep your bonds in your portfolio until they mature. If you sell early—either because you need cash or you change your investment plans—you will be exposed to additional risks including the risks of loss or decreased yield from your ladder.

2. How many issuers might you need to manage the risk of default?
This isn’t a hard-and-fast rule, but because bonds generally must be purchased in minimum denominations (often €1,000). €20,000 or more is often required to achieve a degree of diversification across a broad range of different issuers in different sectors.

3. Build your ladder with high-credit-quality bonds.
Because the purpose of a bond ladder is to provide predictable income over a long period of time, taking excessive amounts of risk probably doesn’t make sense. So you may want to consider only higher-quality bonds.

4. Avoid the highest-yielding bonds at any given credit rating.
You may feel tempted to choose the highest-yielding bonds for whatever credit rating you have chosen, figuring they represent a bargain—more yield for the same amount of risk.
Resist that temptation. You need to understand why a bond is offering a higher yield. An unusually high yield relative to other bonds with the same rating is often an indication that the market is anticipating a downgrade or perceives that bond to have more risk than the others and therefore has traded the bond’s price down (thereby increasing its yield).

5. Keep callable bonds out of your ladder.
Part of the beauty of a bond ladder is the scheduled cash flow; you know when the bonds will mature, when the interest will be paid and you know how much you will need to reinvest. But when a bond is called prior to maturity, its interest payments cease and the principal is returned as of the call date—altering both your cash flow schedule and the schedule of principal coming due.

6. Think about time and frequency.
Another important feature of a bond ladder is the total length of time the ladder will cover and the number of “rungs,” or how often the bonds in the ladder are scheduled to mature, returning your principal. A ladder with more rungs will require a larger investment but will provide a greater range of maturities, and if you choose to reinvest, this means you will have more opportunities to gain exposure to future interest rate environments.

Friday, 2 October 2015

How to invest like Warren Buffett

Investors have long praised Warren Buffett’s ability to pick which companies to invest in. Lauded for consistently following value investing principles, Buffett has accumulated a fortune of over $60 billion dollars over the decades. He has resisted the temptations associated with investing in the “next big thing”, and has also used his immense wealth for good by contributing to charities.

Understanding Warren Buffet starts with analyzing the investment philosophy of the company he is most closely associated with: Berkshire Hathaway. The company has a long-held and public strategy when it comes to acquiring shares: the company should have consistent earning power, good return on equity, capable management, and be sensibly-priced.

Buffett belongs to the value investing school, popularized by Benjamin Graham (whose book The Intelligent Investor is well worth a read for anyone looking to emulate Buffets’ investment style). Rather than focusing on technical indicators, such as moving averages, volume or momentum indicators, value investing looks at the intrinsic worth of a share. Determining intrinsic worth is an exercise in understanding a company’s financials, especially official documents such as earnings and income statements.

How has the company performed? Companies that have been providing a positive and acceptable return on equity (ROE) for many years are more desirable than companies that have only had a short period of solid returns. The longer the number of years of good returns, the better potential for investment.

How much debt does the company have? Having a large ratio of debt to equity should raise a red flag because more of a company’s earnings are going to go toward servicing debt, especially if growth is only coming from adding on more debt.

How are profit margins? Buffett looks for companies that have a good profit margin, especially if profit margins are growing. As is the case with ROE, examine the profit margin over several years to discount short-term trends.

How unique are the products sold by the company? Buffett considers companies that produce products that can easily be substituted to be riskier than companies that provide more unique offerings. For example, an oil company’s product – oil – is not all that unique because clients can buy oil from any number of other competitors. However, if the company has access to a more desirable grade of oil – one that can be refined easily – then that might be an investment worth looking at.
How much of a discount are shares trading at? This is the crux of value investing: finding companies that have good fundamentals, but are trading below where they should be. The greater the discount, the more room for profitability.

Buffett is also known as a buy-and-hold investor. He is not interested in selling stock in the near-term to realize capital gains; rather, he chooses stocks that he thinks offer good prospects for long-term growth. This leads him to move focus away from what others are doing, and instead look at whether the company is in the position to make money.

From being a failing textile business, Berkshire Hathaway is now a multinational conglomerate holding company that oversees and manages a number of subsidiary companies. Among others, the company wholly owns GEICO, BNSF, Lubrizol, Dairy Queen, Fruit of the Loom, Helzberg Diamonds and NetJets, owns half of Heinz and an undisclosed percentage of Mars Inc. It has significant minority holdings in American Express, The Coca-Cola Company, Wells Fargo, IBM and Restaurant Brands International. Berkshire Hathaway averaged an annual growth in book value of 19.7% to its shareholders for the last 49 years. 

Nobody said it would be easy but everyone has to start somewhere! Investment carries risk, seek advice of a professional when required.