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There are many different types of fixed income instruments available: corporate investment grade, high-yield corporates, federal government, municipals, and mortgage-backed securities, to name the most common. Additionally, bonds can be issued with different maturities, some returning principal to investors within a few years, and some extending to 30 years or even longer.
Our bond portfolio will seek to invest in those instruments that provide an attractive return, but do so without taking on higher levels of risk. Higher levels of risk are generally associated with longer-term bonds when interest rates are currently low and deemed likely to go up in the future, as well as low credit quality bonds.
The portfolio will rely heavily, and at times exclusively, on corporate bonds (particularly investment-grade corporate bonds) when we deem them to be a superior risk-reward equation compared with bonds issued by the federal government. We intend to use government bonds, municipals, mortgage-backed securities, and other fixed-rate instruments in a tactical manner when they offer rates that are sufficiently attractive. High-yield corporate bonds may also be used to gain modest exposure to higher-yielding maturities, though the portfolio is unlikely to hold a large percentage of high-yield bonds, especially those of longer duration.
We'll be widely diversified in terms of the total number of bonds the portfolio is invested in. The best way for us to achieve this is to use widely diversified ETFs issued from well-capitalized providers.
The philosophy of this portfolio is not oriented around taxes, which might be a concern in particular for higher-net-worth individuals and for some investors at or near retirement (municipal bonds can be used effectively by investors to get tax-free income). That said, we expect to manage the purchase and sale of ETFs along general long-term Foolish investing norms, and for there to be limited capital gains incurred within the strategy.
The overall portfolio is constructed based on top-down, rather than bottom-up, selection, with the primary considerations being current interest rates, the shape of the yield curve, spreads between corporates and government bonds, and spreads between investment-grade and high-yield corporates.
The portfolio will be constructed with a ladder of individual-year-targeted ("bullet"), low-cost, highly diversified ETFs, each of which holds positions in hundreds of individual bonds.
Corporate bonds will typically be held in a ladder of corporate bond ETFs, each of which is designed to correspond to the performance of investment-grade corporate bond indices. The indices themselves are designed to represent the performance of a held-to-maturity portfolio of investment-grade corporate bonds with effective maturities in one specific year (e.g. an index of bonds maturing in 2016).
High-yield bonds will typically be held in a similar ladder, though with fewer individual ETF positions, as the total exposure to high-yield bonds is likely to be more modest.
The portfolio is not restricted to holding fixed income instruments through ETFs but given the strategy of the portfolio, is unlikely at the present time to use other instruments.
No individual ETF is likely to make up more than 15% of the portfolio. As each ETF is composed of hundreds of individual bonds, no individual bond will be a meaningful position in the overall portfolio.
Exposure to any one publicly traded company’s bonds is unlikely to be very high. Exposure to a particular sector, such as financials, is likely to be significant.
Individual ETFs are monitored on a consistent basis to ensure that they are fully invested, and that the ETF is managed consistently with the description of the ETF in its individual prospectus.
Every month, typically at the beginning of the month, each ETF will make a cash distribution of the coupon payments made by the individual bonds into the ETF. These monthly payments are fairly small as a percentage of the portfolio. The distributions will be invested in existing ETF positions or to open an ETF position on an extended rung of the ladder.
Significant changes, such as selling out completely of an ETF position within the existing ladder, or significantly restructuring the ladder, will occur infrequently — though active portfolio management includes the responsibility to act on significant opportunities when interest rates move dramatically.
Account minimums may apply. All investments involve risk and may lose money. MFWM makes no assurance that investment objectives will be met. Clients should be aware that their individual account results may not exactly match the performance of the Model Portfolios. Past performance is no guarantee of future results.
Motley Fool Wealth Management retains the right to revise or modify portfolios and strategies if it believes such modifications would be in the best interests of its clients.