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.
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.
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.
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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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