This website uses cookies to collect usage information in order to offer a better browsing experience. By browsing this site or by clicking on the "ACCEPT COOKIES" button you accept our Cookie Policy.

Elevating Your Bond Experience: Bond Ladders Vs. An Active Approach

By: U.S. Fixed Income Team & Municipal Fixed Income Team

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

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.

Click Here to Read the Full Article

Originally Posted on November 18, 2019 – Elevating Your Bond Experience: Bond Ladders Vs. An Active Approach

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.

Disclosure: BMO Global Asset Management

This website is for informational purposes only and is not intended to provide a complete description of BMO Global Asset Management’s products or services. Past performance is not indicative of future results. It should not be construed as investment advice or relied upon in making an investment decision. Information on this website does not constitute an offer for products or services, or a solicitation of an offer in any jurisdiction in which such solicitation or offer would be unlawful. Products and services can only be offered by appropriate representatives of the respective manager. Notice to residents of the United Kingdom: For the avoidance of any doubt, the information on this website does not constitute an offer for products or services to persons in the United Kingdom.

BMO Asset Management Corp. is the investment adviser to the BMO Funds. BMO Funds are distributed by Foreside Financial Services, LLC. Member FINRA/SIPC. FINRA’s BrokerCheck.

All investments involve risk, including the loss of principal.

Foreign investing involves special risks due to factors such as increased volatility, currency fluctuation and political uncertainties.

Investors should carefully consider the investment objectives, risks, charges and expenses of the BMO Funds. This and other important information is contained in the prospectuses and/or summary prospectuses, which can be obtained by calling 1-800-236-3863. Please read carefully before investing.

BMO Global Asset Management is the brand name for various affiliated entities of BMO Financial Group that provide investment management and trust and custody services. Certain of the products and services offered under the brand name BMO Global Asset Management are designed specifically for various categories of investors in a number of different countries and regions and may not be available to all investors. Products and services are only offered to such investors in those countries and regions in accordance with applicable laws and regulations. BMO Financial Group is a service mark of Bank of Montreal (BMO).

BMO Asset Management U.S. consists of BMO Asset Management Corp., BMO Asset Management (Canada)® includes BMO Asset Management Inc.

BMO Taft-Hartley Services and BMO Trust and Custody Services are a part of BMO Global Asset Management and a division of BMO Harris Bank N.A., offering products and services through various affiliated entities of BMO Financial Group.

Investment advisory services in the United States are provided by BMO Asset Management Corp., BMO Asset Management Limited, LGM Investments Limited, BMO Global Asset Management (Asia) Limited, Pyrford International Ltd and Taplin, Canida & Habacht, LLC.

Investment advisory services in Canada are provided by BMO Asset Management Inc., BMO Asset Management Corp., LGM Investments Limited, BMO Global Asset Management (Asia) Limited and Pyrford International Ltd.

Financial promotions in the United Kingdom are provided by LGM Investments Limited, Pyrford International Ltd, and BMO Asset Management Limited. LGM Investments Limited, Pyrford International Ltd, and BMO Asset Management Limited are authorized and regulated by the Financial Conduct Authority in the United Kingdom.

Asset management services in Hong Kong are provided by BMO Global Asset Management (Asia) Limited, licensed by the Securities and Futures Commission to conduct regulated activity Type 9 – asset management under the Securities and Futures Ordinance.

Please read the Privacy Policy and Legal Disclosures reached through links above for important information.

Investment products are: Not a Deposit — Not FDIC Insured — No Bank Guarantee — May Lose Value.

Copyright © 2020. BMO Financial Corp. All Rights Reserved.

TM/® Trade-marks/registered trade-marks of Bank of Montreal, used under license.

Disclosure: Interactive Brokers

Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from BMO Global Asset Management and is being posted with permission from BMO Global Asset Management. The views expressed in this material are solely those of the author and/or BMO Global Asset Management and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

trading top