ShareScope | Phil Oakley | Tutorial (2024)

The income challenge

According to the latest Hargreaves Lansdown best buy annuity tables someone with a £100,000 pension pot will get the following fixed income for life at these retirement ages:

• 55 years £4,741
• 60 years £5,181
• 65 years £5,852

Looking at this another way. At 55 it takes you just over 21 years to get your money back. At 60, it takes just over 19 years and at 65 it takes just over 17 years.

You can see why lots of people think this is a bad deal. But how are you going to do better than this? I think it is going to be very hard without taking some risks with your money.

That said, I am not totally down in the dumps about it. This is a complicated problem with lots of possible strategies to tackle it. In these series of articles, I am not going to get into the ins and outs of every possible solution. Armed with ShareScope and SharePad, I am going to introduce you to some ideas as to how to set up an income-producing portfolio.

This week I am going to show you how to do this using bonds.

This article does assume some basic knowledge about how bonds work. (For more on bonds click here.)

What is bond laddering?

A bond ladder is a portfolio of bonds with different maturity dates. So for example, someone with £100,000 might split their bond portfolio evenly into five different parts (these are the rungs of the ladder) with maturities of two, four, six, eight and ten years.

This avoids the risk of buying one ten year bond and locking yourself into a fixed interest rate for a long period of time. Say you buy a ten year bond with an interest rate of 3% and then interest rates rise to 5%. You can't take advantage of these higher rates - apart from reinvesting the 3% interest you receive - because you are locked in until the bond matures. If you tried to by selling your bond you might end up losing a lot of money as the bond will have fallen in price to adjust to the higher rates of interest on offer elsewhere.

By having a bond ladder portfolio, you are able to take advantage of rising interest rates by having bonds mature at regular intervals - in this case every two years. So when the first two year bond matures, your longest maturity bond is now 8 years. To maintain the ten year ladder you need to invest in another bond with a ten year maturity. This will then boost the income of your bond portfolio as the interest rate will be higher.

If interest rates fall, you won't be reinvesting all your portfolio at once and so will be able to hang on to higher interest rates for a while.

As well as reducing the interest rate risk, bond laddering can help you set up a portfolio with regular and predictable cash flows, providing the issuer doesn't go bust of course. This is because the strategy is based on holding the bonds until they mature. The investor therefore knows how much interest and bond repayment (typically £100 per bond held) they will receive each year which makes it a handy way to plan your finances.

Remember this very important point: with an annuity you exchange your pension pot for a guaranteed income for the rest of your life. The point of a bond ladder is that you keep your pension pot and generate an income from it yourself. That is, you retain much or all of your pension pot to bequeath to your loved ones.

How to build a bond ladder using ShareScope or SharePad

1. Decide how many years you want your ladder to last for. Generally speaking, the longer the time you invest for the more income you should receive as interest rates usually - but not always - increase over time.
2. Determine the number of rungs on your ladder - how often you want your bonds to mature. This will give you the number of bonds in your portfolio. The more bonds you have, the more diversified your portfolio will be.
3. What will your ladder be made of? You could just stick to government bonds or add corporate bonds or even fixed term savings accounts.

Putting a bond ladder together in practice is not as easy as it is in theory because it can be quite difficult to buy bonds with the exact maturities that you need. Using the example of a ten year ladder, with rungs of approximately every two years, I've put together a model portfolio with current UK corporate bonds and a government bond (gilt).

SharePad and ShareScope both include information on government and corporate bonds. We've just enhanced the bond data in SharePad so I'll be using this to illustrate the rest of the article. ShareScope users have some of this data and will get the upgrade soon.

So, I'm looking at the Retail bond list in SharePad. These are corporate bonds traded on the LSE's ORB exchange and which can be bought by private investors through their stockbroker. The list also includes a number of government bonds.

In SharePad, there is a bond setting provided which includes columns such as:

• Price
• Dirty price
• Maturity date
• Income yield
• Gross redemption yield
• Coupon

Double-click on the Maturity column heading to sort the list and you should get a list something like this:

Here are the bonds that I have chosen from the list to build a £100,000 portfolio. You will need to research the bonds before you buy. You can find out how to do this in my bond basics article (click here).

As you can see, I've put together a very simple five bond portfolio starting in 2015 with bonds maturing roughly every 2 years until 2025. The life of the portfolio is currently just over ten years and will end in December 2025. This will then change as bonds mature.

So if you want to keep a ten year bond ladder, then when the Unilever bond matures in 2017 you will have to buy a bond that matures in 2027 - so ten years from 2017. The Beazley bond will then become the 2 year rung on the ladder and all the remaining bonds will have moved down two years as well.

As the main focus is on income, the bonds are selected on the basis of their income yield (the annual interest or coupon divided by the current price). In the portfolio above, the income yield ranges from 3.36% to 5.59%.

However, you must pay attention to the total return of the bond as well (its gross redemption yield) which takes into account the capital gain or loss you will receive when the par value per bond (usually £100) is paid back. It's all very well picking bonds that pay you an income but in the current bond market you will probably have to suffer a capital loss to do so. If you are going to set up a bond ladder then you need to work out how much of your capital you want to trade off in return for an income stream.

Is bond laddering a good idea given that bond markets look quite expensive?

If you hate the thought of having lots of your savings tied up in the stock market and want to have a lot of certainty of income then bond laddering is something that you might want to consider - at least for part of your portfolio.

But bond laddering does have some drawbacks. Let's look at the bond ladder I've created in a bit more detail.

So with this very simple bond ladder, I can get £4,625 of income per year until the Unilever bond matures in 2017 (providing all the companies and government behind the bonds are in good health). After that, I might get more or less depending on the level of interest rates and the prices of retail bonds. However, I have very little protection if the cost of living goes up over the next ten years as my income is fixed and will buy less.

That £4,625 is less than a 55 year old man will get with a £100,000 pension pot buying an annuity. He has given that £100,000 away but the bond ladder investor stands to lose £10,828 of their capital if they hold all five bonds to maturity.

For some, that might be a price worth paying for a secure income and a known loss. For others it might be a sign that the bond market is too expensive and that a bond ladder might have to wait until bonds get a bit cheaper and the potential losses come down.

So what would happen if interest rates went up by say 2%?

With something known as modified duration it is possible to estimate what would happen to bond prices if there was a 2% increase in interest rates or yields. I won't get into the calculation here but it would mean that your £100,000 savings pot would buy more bonds and more income with it. The income would increase by over £600 to £5,227 and there would be an overall capital gain of £195.

That's about the same as a 60 year old man currently gets with an annuity with the benefit that you know you have a very good chance of getting all your money back as well.

Look out for the next article in this series on creating an income using shares.