Predictability, Liquidity, and Adaptability

Too often investors are preoccupied with being right. They view the investment process as one in which
each decision will be judged in hindsight as having been correct or incorrect. Nowhere is this more
evident than in the fixed income area where investors, battered by a changing interest rate
environment and discouraged by the low returns currently available, have come to believe that their
next move has to be the right one. In our view this is dangerous thinking, which in all likelihood will
lead to disappointment and more frustration.

There is a better way - one which provides higher current income, greater safety through diversification,
built-in liquidity, dramatically improved predictability of future income, and the ability to automatically
adapt to a changing interest rate environment, usually on the very best terms available. The laddered
portfolio approach does all this, without requiring the investor to forecast future interest rates or to
make complicated re-investment decisions.

What is a laddered portfolio? As its name suggests, the laddered portfolio is one made up of several
fixed income holdings, each having a successively longer term to maturity. Typically each position in
the portfolio would be the same size as the next, and there would be a roughly equal time interval

between each maturity. (See How to Construct a Laddered Portfolio, below) As time passes, such a portfolio would gradually liquidate itself over a number of years. But if instead, when each position, as it matured, was re-invested back out at the long end (i.e. at the top of the“ladder”), then the portfolio would acquire some remarkable properties that make it an ideal solution for the fixed income investor.

Higher current income now…

For 20 years (1973 to 1993) interest rates were always above the highest levels that had ever prevailed over the previous 200 years. The high-water mark reached in 1981 was almost exactly twice as high as at any prior peak. The experience of living through this prolonged period of sky-high interest rates shaped
investor expectations so much that, in the more than two decades since rates set their highs, investors
have kept their fixed income capital invested in short-term instruments for fear that a move to
higher rates was just around the corner.

Since long-term interest rates have been higher than short-term rates almost all of that time, the decision
to keep re-investing in short-term instruments has meant that investors have consistently accepted less
current income than has been available. Even though the simple decision to extend term would have almost always provided an immediate boost to income, most investors have been and continue to be reluctant to commit to a longer term  for fear that rates will rise, leaving them obliged to
accept a sub-par income for the full term of the bond or term deposit.

In our view, this tendency to reduce the investment process to an all-or-nothing choice between short or
long-term is not far different from moving your chips from one number on the roulette table to another-the payoff, if you are right, can be big, but the cost of being wrong is always too high.
In effect you are gambling that your forecast of future interest rates will be right.

The “laddered approach” removes the necessity for you forecast where rates are headed and focuses
instead on the factors that are of most concern to the fixed income investor-safety, high current income,
predictability of future income, and adaptability to changing conditions.

A Bond Ladder Today

The laddered approach spreads out your fixed income capital over a range of maturities, which,
on average, are appropriate to your financial circumstances. In the example above, this would
immediately boost portfolio income for the coming year by 97% (or by $8,550 in a $500,000 portfolio)
over the $8,750 that reliance on a one-year Treasury Note would provide.

A Bond Ladder Four Years Later

… And later

What’s more, by following this approach, your income in all likelihood will go on rising for several
years because the shorter-term, lower-yielding issues in the initial portfolio will gradually be
replaced by longer-term, higher-yielding issues (see table on the previous page). This comes about
because, at any given moment, long-term rates are almost always higher than short-term ones. (Indeed
over the past 51 years, long rates were higher than short-term rates 92% of the time.) And within another three years all the issues would be yielding the nine-year rate of 4.30% and yet the portfolio would still have an average term to maturity of only five years!

Built-In liquidity and safety

It’s true that such a portfolio does not offer the“next-day-100-cents-on-the-dollar” liquidity that
some bank accounts or T-Bills come close to providing. But it does offer a high level of liquidity, consistent with the real needs of most investors, with part of the portfolio maturing at regular intervals. At all events, each instrument in the portfolio could be sold any time at short notice. And while the price
realized might be more or less than the cost the investor had originally incurred, depending on what
interest rates had done in the interval, that sort of ‘emergency’ liquidity is always available on the rare
occasion it is required.

Safety is usually also high on the fixed income investor’s list of priorities. Here too the laddered
portfolio offers great scope for lowering risk through diversification. In an era when political uncertainty,
the changing opinions of rating agencies, and fluctuations in global currencies can all affect the
ultimate worth of even the most conservative securities and savings vehicles, it just makes good sense not
to put all your eggs in one basket. A well-chosen portfolio can substantially mitigate all such risks that your capital is inevitably exposed to.

Predictability versus uncertainty

Another great virtue of the laddered approach is the high degree of predictability of future income that it
affords. Many investors’ savings roll over every year or two. That means the income provided by these
savings can and does fluctuate, unpredictably from year to year. For example, not so very long ago
in 2000 a retired couple, depending on a $500,000 portfolio for supplementary income, invested
(as most were and still are) in short-term notes and deposits averaging about one year in term, enjoyed a
pre-tax income of about $30,000. But just three years later in 2003 their income had fallen by almost 80% to just $6,500. It goes without saying that it is very hard to plan a retirement when your income from one year to the next is a completely unknown quantity.

While the income generated by a laddered portfolio would also change in line with the overall direction
taken by interest rates, it would do so gradually since only a fraction of the portfolio would roll over every
year or so. Your income would inevitably rise or fall over time, but not in a way that would force you to
change your lifestyle dramatically in the short run, as has happened to so many investors over the past
few years.

Perhaps the greatest attribute of the laddered portfolio is its implicit acknowledgment that each individual’s ability to forecast interest rates is imperfect at best. Of course, if we knew exactly where interest rates were headed next then we would always be in 30-day T-Bills when rates were rising and in 30-year bonds when they were falling. But the reality is that even the wisest or luckiest of us are going to be wrong sufficiently often that our investment strategy must build in a large margin for error. Investing
exclusively in one-year bills or deposits does not provide that margin as many of us have learned
painfully over the past several years. The laddered approach allows us to roll with the interest rate punches, while diversifying away many of the risks which lay seen or unseen in today’s complex investment environment. As such it represents the best and most conservative strategy for the fixed income investor.

How to Construct a Laddered Portfolio-Step By Step

1. Choose an appropriate average term. This should be the length of time over which the income from
your portfolio needs to be highly predictable. Most investors in 2000 had an average term of one year
or less. As a result, three years later, their annual incomes had fallen by as much as short-term interest
rates had, i.e. by almost 80%. Contrast this with the position of the couple who had a laddered portfolio
with a five-year average term: by the end of 2003 their income had fallen by less than 14%. Their
income will still move in the same direction as interest rates over time, but never so abruptly as to force
changes in lifestyle without warning. In our view, most individuals are best served by an average term
of between four and seven years.

2. Calculate the longest maturity to be used in the portfolio. In a portfolio where each individual
position will be approximately equal in size and spaced at even intervals apart, then the longest term
instrument to be included would be roughly twice as long as the average term. For example, if an
investor had decided that an average term of five years was appropriate, then the longest term
to be included in the portfolio would be about ten years (2 X 5).

3. Determine how many positions to use (i.e. how many steps on the ladder). The more positions to be
used, the shorter the interval between each maturity date, and hence the smoother the transition from
one interest rate environment to the next. On the other hand too many positions can make it difficult
to reinvest interest in a timely and efficient fashion. Our recommendation for most portfolios is one
maturity per year of the ladder. For example, in a 10-year ladder, we would suggest 10 positions, each maturing one year apart.

4. Adhere to a re-investment rule. In order to ensure that the laddered portfolio retains the same average
term over time, each time an issue matures the proceeds should be re-invested out at the longest
acceptable term as determined in Step 2 (i.e. at the top of the ladder).