Climbing the Ladder

Many advisors focus only on the possibility that the principal value of a 5- or 7-year bond could fluctuate–which it can. At some point it becomes apparent to you and to your clients that accepting a couple of points of price risk is no different than accepting several points of income risk.

Investors who are unhappy about this yield erosion often compound the damage by going from one extreme position to another (a very long maturity bond investment, or a gimmick fund) at exactly the wrong time. Check out chart 3 (below, right), which shows 30-year U.S. Treasury bonds and their relationship to bond mutual fund sales. Because yields and bond prices are inversely correlated, bond prices are high when yields are low. You would expect people to buy fewer bond funds when bond prices are high, but that’s not what the mutual fund sales figures show. In fact, investors do the opposite in an attempt to time the market. It’s almost exactly wrong in a very predictable way. You can see that in almost every peak and trough of interest rates in the last 18 years–including the current one–investors did the exact wrong thing. It’s no wonder that some investors hate bonds. They don’t have a sensible bond investment strategy.

And typically, all the attention of bond market commentators is focused on long-term bond yields. Intermediate maturity bonds are overlooked. But these bonds not only provide very good, long-term average returns, they do it with half the volatility of long-term bonds.

What do you say if your investors want to buy only an individual bond, versus investing in a bond fund? One big issue is that with an individual bond there’s no guarantee that you’ll be getting it at the best price. You’re competing with the greater buying power of bond dealers, mutual funds, and other institutional investors. What’s more, the price an individual buyer may be quoted on some bonds can vary widely from dealer to dealer.

To be sure, advisors can put together a bond ladder for an individual client using 15 to 20 bonds. At best, the portfolio will have perhaps two maturities per year. So, investors are exposing themselves to a fair amount of risk, not so much in terms of market prices, but in reinvestment. You’re basically called upon to guess interest rates for the remainder of the year. Is that a good time to reinvest the money, or should you stay in cash, or should you go extra long?

Laddered Funds

By contrast, a laddered bond mutual fund will ideally have many more maturity dates on that ladder. Not just one or two bonds are maturing in a given year; the number is more like 20 or 30. Because a bond mutual fund is in the market all the time, reinvestment risk is thus smoothed out (chart 4, right). This is one bond investment strategy that both appeals to common sense and has delivered good results over time. Laddering tends to outperform other bond strategies because it simultaneously accomplishes three bond investor goals: Producing attractive income for the price risk incurred; capturing price appreciation as bonds age and move down the yield curve; and spreading reinvestment risk. Essentially, you are hedging your bets. If rates go up, you always have some money coming due for reinvestment; if rates go down, you don’t have it all coming due at once, thereby preserving your higher yields (and price appreciation) in the rest of the portfolio.

Three Scenarios

Consider three interest rate scenarios where income streams are mechanically reinvested in a very simple laddered bond portfolio over a period of 10 years (chart 5, bottom right). The center line represents no change in interest rates, providing a steady return each year in the laddered portfolio. That return often happens to be fairly close to the return of the longest maturity bond in the portfolio. But your duration is shorter at the onset, and your reinvestment risk is spread out in an intelligent manner.

If interest rates rise immediately after you assemble the laddered portfolio (follow the bottom line), bond values initially drop, but only temporarily. Time passes, and the ladder has maturing bonds each year. This gives the portfolio a stream of cash flow to reinvest in new, cheaper, higher-yielding bonds, even if interest rates remain at the new higher levels. Even the bonds that don’t mature will move down the new, higher-yield curve, which helps them recover value prior to actual maturity dates.

Don’t Be Depressed

The laddered portfolio creates a consistent pattern of investment, much as dollar cost averaging does for an equity portfolio. Without maturing bonds, the fund manager would be forced to sell bonds at depressed prices as a way of generating cash for reinvestment.

As proceeds from maturing bonds are reinvested in higher-yielding bonds toward the back end of the ladder, the portfolio’s yield gradually increases. Before long, the average annual total return begins to exceed that of the same starting portfolio if interest rates have not increased.

Suppose you invest and interest rates fall (the top line)? Initially, the bond portfolio’s return rises in value as bond prices get marked up. Ultimately, as those bonds mature and proceeds are reinvested in lower-yielding bonds, the portfolio’s long-term return is lower than it would have been under the first two scenarios. The income stream also decreases, but only gradually because the longer-term higher yielding bonds continue to be held in the portfolio, and the income generated continues to be the average of all the bonds.

If your client is open to a sensible investment course no matter which way interest rates move, any time is a good time to build or invest in a laddered bond fund. With a laddering strategy, it’s possible to get attractive returns. It’s the smart way to increase the portfolio’s return while minimizing both market risk and reinvestment risk.

Brian McMahon is president and chief investment officer of Thornburg Investment Management in Santa Fe, New Mexico. For a more detailed report on laddered bonds, e-mail the author at [email protected].