The Income Ladder Strategy: Combining Bonds, Credit and Dividends

The idea of regular, consistent payments is a critical part of an income-focused portfolio. Ensuring that a portfolio actually looks and works that way across extended periods can take a bit more planning. It’s not as simple as bunging everything into a bond and taking a monthly coupon.

After all, you also need to factor for growth, market conditions and inflation – and receiving all your income in one hit may not actually be helpful from a psychological perspective too.

One strategy that financial advisers typically use is known as laddering. While it is often typically considered with regards to bonds, you can equally apply it across other types of assets, the same principles apply.

The Income Ladder Strategy

An income ladder encourages you to spread your investments that might offer you different payoffs at different points. It can also help manage a variety of risks, such as interest rate risk or reinvestment risk. It is both a form of diversification and method of supporting a steady income stream.

The simplest way to think of it is blending different assets to ensure income not only at different points in time but with different return potential. You would never simply have one 10-year Government Bond as your sole income stream, nor would you just rely on the dividends from one of your tried-and-true blue-chip shares. It’s a balance of assets.

One of the benefits of using a laddering approach is that it can aid in consistency and reducing volatility. While there can be some work upfront in setting it up and it does require ongoing active management, it can be less time-consuming compared to some other forms of income strategies.

By comparison, another popular form of income strategy is known as a barbell approach. This is where you would concentrate your portfolio in just short-term and very long-term assets, without using medium-term assets. It can be flexible, but is more sensitive to rate changes and requires active management.

Laddering in Practice

If you look specifically at a ladder strategy for your bond or credit investments, you would consider spreading across different durations, different coupon frequencies and across both government and corporate bonds, along with private credit senior secured loans.

If your portfolio was a ladder, each rung would be a bond with a different maturity date and coupon.

You’d also consider bonds from different regions that are likely to be subject to different rate regimes. Some of your investments might use fixed rates, while others might be floating (tied to the central bank cash rate). This might mean using a mix of funds, or selecting a diversified option.

You’d also spread across sectors – for example, you wouldn’t just use private credit focused on the property market as if something goes wrong in that sector, it will not only affect your interest payments but could risk your principal.

Taking a closer look at a diversified income fund can demonstrate how this might look in practise.

For example, the Perpetual Diversified Income Active ETF (ASX: DIFF) aims to offer quarterly income by using a mix of investment grade bonds (with the bulk spread across BBB, A, AA, AAA and Cash) and across maturity dates from under a year to more than 7 years, spread across sectors, and seniority.

Or MST Australian Bond Fund uses government and corporate bonds, mortgage backed securities, asset backed securities, cash and enhanced cash instruments to offer quarterly income payments.

From the perspective of equities, you might consider dividend-paying investments that have varying time periods for paying dividends, use positioning in different sectors or accessing franking to add an extra option for income at tax-time.

For example, the Plato Australian Shares Income Fund uses dividend rotation to avoid sector biases and focuses on franking credits as part of the income stream. Or the JP Morgan Equity Premium Income Active ETF (ASX: JEPI) uses dividends along with premiums from selling index call options.

Considering a Laddering Strategy?

An income ladder typically suits more conservative investors, but as it takes time to set up, it may be valuable to have an expert manage it on your behalf – or allocate portions to experts to manage for you.

The key is diversification across maturity dates, coupons, types of rates (floating v fixed), sectors and regions for the bonds and credit portion of the portfolio, and factoring timing, typical size of dividends and the potential for franking while balancing the equity income side of the portfolio.

Your aim should be consistent and stable income payments over time, with careful reinvestment to fill gaps as assets mature and an eye to managing risks like inflation and rates. Each rung of your ladder needs to fill a specific gap/step for your overall portfolio.

Funds Mentioned

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.