U.S. Fixed Income

Elevating your bond experience: bond ladders vs. an active approach

While investors generally agree that fixed income is an indispensable element of most portfolios, there are different approaches as to how to invest in fixed income.
November 2019

While investors generally agree that fixed income is an indispensable element of most portfolios, there are different approaches as to how to invest in fixed income.

With the recent fluctuation of interest rates, we have seen the topic of investment approach resurface as investors seek to weather the volatility while capturing the benefits of the asset class. Laddering, in particular, has been proposed as a fixed income solution agnostic to changes in the market.

We view fixed income strategy implementation for client portfolios in the context of the four roles fixed income has historically served for clients: income, diversification, capital preservation and liquidity. In the following piece we address the difference between “laddering” bonds and what is known as an active or total return approach, focusing on these essential aspects of fixed income. Both laddering and active strategies can be implemented for either taxable or tax-exempt (i.e., municipal) bonds.

What is a bond ladder? Simply put, a bond ladder is constructed by purchasing bonds with staggered maturities over a number of years, typically 7 to 10, in which the principal of bonds that mature on the first rung of the “ladder” is then reinvested in new bonds with maturities on the far end of the “ladder.”

What is active fixed income management? Active management generally seeks to outperform a designated benchmark. By contrast to a ladder, this approach is less likely to wait for bonds to mature and more likely to opportunistically seek to purchase and sell securities to add value, taking advantage of market inefficiencies.

Why ladder bonds? One of the primary arguments behind this approach is that even if rates vary over the holding period and impact bond pricing short term, the individual bonds will return to par at maturity and return their full principal (assuming no defaults). In this way, the investor becomes indifferent to the short-term changes in the rate environment, while collecting income.

Challenges of laddering? The arguments for laddering have some appeal, but upon examining the four roles fixed income serves for clients, we find that an active approach is generally safer (provides better diversification and capital preservation), generates more attractive income and offers better liquidity.

We view fixed income strategy implementation for client portfolios in the context of the four roles fixed income has historically served for clients: income, diversification, capital preservation and liquidity.

The discussion of investment approach reminds us of the children’s book series “Choose your own adventure.” Each investor must consider their options and choose their own path, but to aid in this decision, we provide the crib notes to this adventure.

1) Income:

Investors may forgo significant income potential by focusing only on highly-rated, short or intermediate maturity credits.

i) Maturity targeting: Laddering is deliberately agnostic to market events. For example, if longer maturity corporates are cheap relative to short maturity or vice versa, these views are not generally reflected in a ladder portfolio.

In fact, to the contrary, ladders are typically invested in bonds with maturities inside of ten years, which normally trade at tighter spreads (lower yields). Because of the large demand for laddered strategies, longer maturity bonds may offer additional yield, particularly in the municipal space where the large demand for laddered strategies can suppress shorter-term yields. The chart below shows the relative steepness of a highly rated municipal yield curve, known as BVAL, vs. U.S. Treasuries as of September 30, 2019.

Investors may forgo significant income potential by focusing only on highly-rated, short or intermediate maturity credits.

U.S. Treasury yield curve vs. Bloomberg BVAL yield curve

Source: Bloomberg and BMO Global Asset Management

ii) Quality diversification: Ladders typically invest in fewer individual bonds (20 – 40 bonds is typical) and therefore generally invest in higher quality issuers given the potential impact of a default. However, as lower quality issuers (both investment grade and high yield) typically offer additional income, a diversified portfolio that includes a mix of credit qualities is likely to offer a higher overall yield to investors.

iii) Reinvestment risk: Ladders have historically performed best in rising rate environments, where proceeds from maturing bonds can be reinvested at the long end of the ladder at higher interest rates. In a declining interest rate environment, the inverse can be true, as bonds purchased at higher rates will mature and then be reinvested at lower rates. An active strategy, which can take advantage of temporarily mispriced securities or relative value opportunities across the yield curve, can add additional income to a portfolio over time.

iv) Bond math: When considering the yield of a bond, embedded in that yield is an assumption about the rate at which coupons can be reinvested. A more concentrated portfolio faces the risk that cash flows will be concentrated and may be reinvesting at a point when market yields decline; by contrast a more diversified pool can effectively ‘dollar cost average’ their coupons into the market.

2) Liquidity:

i) Liquidity: Bond ladder proponents frequently argue that bond funds are vulnerable to the actions of other investors. This is true, but generally only for very large redemptions. Alternatively, if the bond ladder investor is the one who needs liquidity for any reason, they would be better suited to draw liquidity from a pooled vehicle rather than a laddered portfolio, as selling small lot sizes can have a negative effect on total return (see below).

ii) Trading costs and inefficiencies: While the taxable fixed income market may not be quite as fragmented as the municipal bond market, there are still thousands of CUSIPs to consider, and trading costs for smaller, retail block sizes can negatively impact an investor’s total return. As an example, a hypothetical $1 million 10 year bond ladder with 20 different bonds would have an average position size of $50,000. A recent study from S&P (March 2018) shows that the average retail transaction cost (block sizes < $100,000) for investment grade municipal bond trades is considerably higher than for larger trades:

  • .41% for institutional investors
  • .90% for retail investors

Similarly, the same study showed the average retail transaction cost for investment grade corporate bonds to be higher, as well:

  • .36% for institutional investors
  • .64% for retail investors

Holding small block sizes can negatively impact pricing and returns of the ladder portfolio over time. A pooled solution, managed by an institutional asset manager, can use its buying power to potentially invest at better prices with lower transaction costs. This is true as well in the new issue market, where it can be difficult for retail investors to access attractively priced bonds directly.

Holding small block sizes can negatively impact pricing and returns of the ladder portfolio over time.

3) Capital preservation:

i) Default risk: While the default risk of any individual investment grade bond is historically quite low, the negative impact to an investor who owns only 20 – 40 is potentially significantly higher than for an investor owning a fund with potentially hundreds of securities.

By owning a meaningfully higher number of bonds in a fund, no single bond is likely to negatively impact performance in the unlikely event of a default, but the power of that additional income across a large number of bonds can be meaningful for investor returns over a market cycle. Investment grade defaults have been uncommon, but can be impactful in a concentrated portfolio.

Moody’s cumulative rolling 10-year default rates

Source: Moody’s Investor Services

ii) Active strategies: An active approach can be beneficial to capital preservation as the manager has the ability to position defensively if they perceive market risk. As an example, a manager may choose to “barbell” a given portfolio by overweighting exposure to both ends of the yield curve: investing longer on the curve to pick up the additional yield that is present, but also investing in floating rate securities at the front end of the yield curve, that can reset higher as interest rates rise. Further, an active manager could choose to adjust a portfolio’s overall duration to make it more or less sensitive to changes in interest rates (and thus changes in price). This approach can offer some protection against rising rates.

Bond laddering is effectively a buy and hold strategy, relying on the investor’s ability to select bonds well at the outset and presumably monitor them until maturity. While the manager of the ladder can substitute individual bonds, they are likely doing so only after the credit has deteriorated, thus likely making the change at a loss for the investor. By contrast, pooled solutions generally involve more active strategies, which offer an opportunity to outperform.

Harry Markowitz, Nobel laureate in Economics and considered the progenitor of Modern Portfolio Theory, has described diversification as “the only free lunch in finance.”

4) Diversification:

Harry Markowitz, Nobel laureate in Economics and considered the progenitor of Modern Portfolio Theory, has described diversification as “the only free lunch in finance.” An active approach better capitalizes on this “free lunch” than a laddered approach, which eschews the full benefits of diversification for a more concentrated portfolio.

i) Sector diversification: Laddering, or any concentrated approach, risks missing the broad diversification of fixed income sectors. For example, taxable bond ladders are typically made up of corporate bonds, whereas bond funds often allocate to a broader universe which could also include Treasuries and securitized products. Municipal ladders may also lack diversification as investors may focus only on their home state to capture state income tax savings, but may inadvertently become overexposed to that particular state’s economy as a result.

ii) Callability: Bonds with call features can be problematic when implementing a ladder, as this call feature can result in unknown timing of the return of principal. Today, approximately 55% of corporate bonds, along with 44% of municipal bonds with maturities between 1 and 10 years, have call features. This serves to reduce the opportunity set for ladders, and may lead to adverse selection bias if stronger issuers are able to build call features into their issuance.

The chart below illustrates the non-callable, A- rated corporate bonds with maturities of 10 years or less within the Bloomberg Barclays Aggregate Index as of September 30, 2019:

Primary opportunity set for ladders within Bloomberg Barclays Aggregate Index

Source: Bloomberg and BMO Global Asset Management

iii) Access to markets: Funds and commingled vehicles can purchase certain bonds that individual investors below a certain level of assets cannot. For example, 144a registered bonds, which currently represent more than 20% of the U.S. credit market, require an individual investor to be a Qualified Institutional Buyer (“QIB”) to transact this certain bond type. A QIB must have more than $100 million in investible assets. An investor can access these funds, which qualify as QIBs, even if they do not themselves qualify as QIBs.

iv) Timing of implementation: Because bonds are less homogenous than equities, funding a ladder is subject to availability of new issues or attractively priced bonds in secondary markets at the time of funding. Funds build diverse exposures over various time periods averting this diversification limitation. Similarly, if a ladder account must sell a position for account specific reasons, this could alter the portfolio structure and require additional time to bring the account back in line with the overall strategy.

144a registered bonds, which currently represent more than 20% of the U.S. credit market, require an individual investor to be a Qualified Institutional Buyer (“QIB”) to transact this certain bond type.

How do you know if you picked the right adventure?

Performance measurement: How does one evaluate the success of an investment strategy? Were the right bonds chosen? Could other bonds have delivered better yields? Pooled vehicles are benchmarked to standard benchmarks that allow the investor to understand how their portfolio has performed relative to the market. Ladders are often not benchmarked, so evaluating the strategy’s performance is difficult.

So, which adventure do you choose?

In evaluating the four roles fixed income can play in a portfolio, we find that an active approach is generally superior in delivering on clients’ needs in each of the four factors. Active approaches, generally speaking, can offer higher yields with greater diversification, thus better preserving capital while increasing investor liquidity.

Laddering may be a suitable strategy in specific instances, but we believe many of the advertised benefits are overstated. While some investors may find psychological comfort in owning individual bonds, we believe the costs investors must pay in both risk and return outweigh the potential benefits.

Finally, an active approach can be better evaluated on the results it delivers and thus the manager of the strategy can be better held accountable. While we believe investors should choose their own adventure, we know which adventure we’d choose.

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All investments involve risk, including the possible loss of principal.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. All of these factors can subject the funds to increased loss of principal.

Keep in mind that as interest rates rise, prices for bonds with fixed interest rates may fall. This may have an adverse effect on a Fund’s portfolio.

Credit risk is the possibility that an issuer will default on a security by failing to pay interest or principal when due. Lower credit ratings correspond to higher credit risk. Municipal bonds are subject to risks including economic and regulatory developments in the federal and state tax structure, deregulation, court rulings, and other factors.

An investment in money market funds is neither insured nor guaranteed by the Federal Deposit Insurance Corporation. You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. The Fund may impose a fee upon sale of your shares or temporarily suspend your ability to sell shares if the Fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the Fund is not a deposit of BMO Harris Bank N.A., or any of its affiliates, and is not insured or guaranteed by the FDIC or any other government agency. The Adviser has no legal obligation to provide financial support to the Fund, and you should not expect that the Adviser will provide financial support to the Fund at any time.

Municipal bonds are subject to risks including economic and regulatory developments in the federal and state tax structure, deregulation, court rulings, and other factors. Interest income from tax-exempt investments may be subject to the federal alternative minimum tax (AMT) for individuals and corporations, and state and local taxes. Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment. Municipal bond interest is not subject to federal income tax but may be subject to AMT, state or local taxes.

Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index that covers the U.S. investment-grade fixed-rate bond market, including government and credit securities, agency mortgage pass-through securities, asset-backed securities and commercial mortgage-based securities. To qualify for inclusion, a bond or security must have at least one year to final maturity, rated investment grade Baa3 or better, dollar denominated, non-convertible, fixed rate and be publicly issued.

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