Investing

Bond Ladders Seen as a Prudent Approach to Fixed Income

Bond ladders can be built to perform well in a variety of interest rate environments.

By Lee Barney editors@strategic-i.com | September 14, 2015

Bond ladders are a prudent way to invest in fixed income, says Josh Gonze, portfolio manager with Thornburg Investment Management in Santa Fe, New Mexico.

To create a bond ladder, an investor selects a timeframe and builds a portfolio of bonds with evenly staggered maturities so that a portion of the portfolio will mature each year, Gonze says.

“For example, in a limited-term ladder, we’ll put 10% of the portfolio in bonds in each of the first 10 years of the yield curve,” he says. “So, we’ll have 10% of the bonds in one-year bonds, 10% of the bonds in two-year bonds, 10% of the bonds in three-year bonds, and so on. For intermediate bond ladders, it’s the same concept, but we roll it out further along the yield curve—one to 20 years with 5% of the portfolio invested in each year.”

Thornburg likes bond ladders for a number of reasons, he says. They produce a stable net asset value (NAV) along with “an attractive stream of cash flows that we can pass on to investors as monthly distributions,” Gonze says. “The ladder does something else for us. It allows us to benefit from the aging of bonds as they roll down the yield curve. Remember, the yield curve is almost always upward sloped.”

Generally, as a bond ages, it rolls down the yield curve and is therefore priced at progressively lower yields.

“For example, when a 10-year bond ages for a year, it becomes a nine-year bond with a lower yield. Its market value has therefore risen. We want to capture that. It puts the wind to our backs and produces a source of upward price pressure that we will build right into our NAV and let flow through to the shareholder.”

One of the primary benefits of a bond ladder is it is “a defense against a rising rate environment,” says Josh Tschirgi, an adviser at Somerset Wealth Strategies in Portland. “If you buy a three-year bond and rates rise, that bond will be delivering yield that is lower and worth less. With a ladder, the bonds are constantly maturing, and you can reinvest them at a higher interest rate if rates rise. But even if rates decline, because bond prices and interest rates have an inverse relationship, bond prices will rise to a premium. The bond ladder is an all-weather strategy.”

NEXT: Other benefits 

Gonze says some portfolio managers approach the yield curve by relying on economists to make interest rate predictions, but with a bond ladder you don’t need to do that “because it is a rules-based approach to interest rates,” he says, adding that interest rate predictions often backfire.

In fact, Thornburg back-tested over the past 30 years the bond ladder approach versus two other approaches to the yield curve—a barbell where you invest only in long and short bonds and a bullet where you pick only one maturity—and found that in 60% of cases examined, the ladder strategy beat the other two approaches by at least 25 basis points annually. “Over 30 years, this is quite a bit of money,” Gonze says.

Another benefit is that, because the bonds are constantly maturing, the portfolio produces an organic source of cash flow that equips the portfolio manager with cash so that if there is a bond he wants to buy, he doesn’t need to sell a bond, which produce capital gains and losses that would need to be passed on to shareholders, he says.

As to the types of bonds that work best in bond ladders, “it is more efficient to create a ladder with corporates, Treasuries or agencies, rather than municipals, because they are widely available with different maturities,” says Jay Sommariva, vice president and senior portfolio manager at Fort Pitt Capital Group in Pittsburgh.

It is also important to select non-call bonds because they have a firm maturity date and you can know when the bond will mature, Gonze says. “With a callable bond, you don’t know when you will be paid,” he says.

As to how long the duration of a bond ladder investors should be in right now, because interest rates are expected to rise, Fort Pitt Capital Group has reigned in its bond ladders to six years or less, Sommariva says. Once interest rates rise, “we will invest further out on the yield curve.”

Sommariva also believes bond ladders would benefit almost all investors, particularly those looking for a consistent cash stream every year. “For retirees, ladders could be very beneficial because of that stream,” he says. “I think it is a really good, prudent investment policy that investors should look at because it protects you if rates go higher and it provides yield.”