Bond laddering combines the safety of short-term bonds with the higher yields of long-term bonds.
Managing a Laddered Bond Portfolio
By Jeff Brown | Contributor
March 9, 2016, at 10:29 a.m.
It’s been a tough few years for fixed-income investors. Actually, it’s been a tough decade.
Yields on bank accounts, money markets and bonds have repeatedly dipped to record lows, and haven’t gone up to a «normal» range in ages. The 10-year U.S. Treasury has paid less than 4 percent since 2008, and currently offers less than 2 percent. You’d need an awfully big account to live off that.
So what does this do to the standard «bond laddering» strategy? Is it time to tweak it? Or should you stick with the traditional setup?
Traditionally, you might have a $100,000 fixed-income portfolio holding U.S. Treasury bonds with maturities of one, two, three years – all the way to 10 years, or even 20 or 30. After a year, the one-year bonds mature, and the proceeds are used to buy new long-term bonds to keep the process going. The idea is to combine the safety and liquidity of short-term bonds with the higher yields but greater risk of long-term bonds.
Currently, a Treasury with one year to maturity yields about 0.67 percent, the five-year 1.36 percent, the 10-year 1.85 percent and the 30-year about 2.65 percent, with other bonds falling in between.
Those rates are pretty low. Does it really make sense to tie money up for five, 10 or 30 years if it means earning next to nothing?
Many experts say it does, because the annual reinvestment of proceeds from maturing bonds allows the portfolio to adjust automatically as yields rise and fall. A year from now, your $10,000 from maturing bonds could buy 30-year bonds yielding 3 or 4 percent, or more, if rates do rise.
«Bond ladders are designed to take the guesswork out of interest rates,» says Sharon Stark, fixed income strategist for D.A. Davidson & Co. based in Great Falls, Montana. She says investors should refrain from radical portfolio surgery as conditions change.
Moreover, interest earnings aren’t the only reason to own bonds, bond mutual funds or exchange-traded funds. Another reason is diversification, since bonds and other assets, like stocks, often march to different drummers – when stocks are down, bonds may be up. That doesn’t always work, but it works often enough. This diversification benefit persists even when the bond holdings are not especially generous.
Also, bonds can offer investment gains. If prevailing interest rates fall, buyers will pay a premium for an older bond that pays more than the current rate. In 2014, for example, the 10-year Treasury returned nearly 11 percent due to price gains as yields dropped. The gains are bigger for bonds with more years to maturity, since there is more time to enjoy the above-market earnings.
Today, however, yields are so low that they can’t go much lower. In fact, there’s a better chance yields will drift up. That would have the opposite effect, causing values of older, stingier bonds to fall. In 2013, the 10-year Treasury lost more than 9 percent as yields drifted up.
Thus the quandary: should you reduce the risk by cutting back on the long-term bonds in your laddered portfolio? Not only would the portfolio be safer with more money in short-term bonds, you’d have fairly ready access to cash if conditions changed, allowing you to buy long-term bonds again after they became more attractive.
Unfortunately, history shows that it’s very hard to predict when interest rates will rise or fall. Trying to time the bond market can be just as challenging as trying to time the stock market.
«A laddered strategy is intended to have equal rungs each year, allowing reinvestment in the longest run of the ladder whenever a bond matures,» says Bill Gurtin, CEO of Gurtin Fixed Income Management in San Diego and Chicago. «For that reason, a manager’s method for building a bond-laddered strategy should not differ based on the current low level of yields.»
Others suggest minor surgery is OK. Stark says it can make sense to use a heavier emphasis on shorter-term bonds when rates are likely to rise, and on longer-term bonds when they are expected to fall.
One option is to keep the current ladder intact, but to put new savings into the short end. Or one could split the difference, emphasizing the middle to get a bit more yield without too much risk.
In a late-February analysis, Kathy A. Jones, chief fixed income strategist at Charles Schwab, suggests that 80 percent of a fixed-income portfolio be devoted to «core bonds» such as Treasuries and investment-grade corporate and municipal bonds.
«Within the core bonds allocation, we continue to believe that the best risk/reward opportunities exist in intermediate-term maturities,» she says in the analysis. «For Treasuries and corporate bonds, that means five to 10 years.» Seven to 12 years would be desirable for municipals, she says.
She recommends riskier holdings such as junk bonds and foreign bonds for the remaining 20 percent of the portfolio. Overall, her strategy would emphasize safety over yield.
Choosing bonds can be tricky for ordinary investors, which is why many resort to mutual funds. One option is to own one fund specializing in short-term bonds, another with intermediates and a third with long-term bonds. And now there are a few bond-laddering ETFs, such as iShares Core U.S. Treasury Bond ETF (ticker: GOVT). Some have a specific maturity date the investor matches to needs such as college expenses or retirement.
«The pros of bond laddering ETFs and mutual funds are that they are more cost, tax, and time efficient than building [a laddered portfolio] yourself,» says Matthew Granski, an analyst at Miracle Mile Advisors in Los Angeles. He cautions, though that many of the laddered ETFs are too new to have much of a track record.
«Mutual funds have been practicing this for decades, but these types of ETFs have only come around recently and investors still seem to be waiting to see if there are any hiccups with bond-laddered ETFs,» he says, recommending that investors consider actively managed bond mutual funds instead.
The trick with managed funds, of course, is to keep fees as low as possible. That’s especially important today, as fees, even if comparatively modest, can chew away at a fund’s stingy interest earnings.