Laddering a bond portfolio is one method of managing interest-rate risk and liquidity needs while also giving yourself a chance to earn higher yields than those offered on short-term bonds. There are all sorts of bond ladders fixed income investors can build. They can be spread out over multiple decades or just a few years. They can consist of only bond funds, just individual bonds, or a combination of both. And their focus could be within one segment of the bond market or spread out across various segments (Treasuries, corporates, munis, etc.).
When it comes to building bond ladders, there are a few general rules investors should employ:
1. In a low benchmark-rate environment in which spreads are at historically average or below-average levels, consider sticking with individual bonds on the furthest-dated parts of the ladder, and, if you are so inclined, work your way to defined-maturity funds as the time to maturity shortens. In this environment, remain extra vigilant when considering non-defined maturity bond funds.
2. In a low benchmark-rate environment in which spreads are at historically high levels, consider sticking with individual bonds on the furthest-dated parts of the ladder. Additionally, under that scenario, it is acceptable to work in non-Treasury bond funds with slightly longer maturity profiles than those funds in scenario (1).
3. In a moderate benchmark-rate environment in which spreads are at historically average or below-average levels, favor individual sovereign bonds and individual high-quality corporates and munis. If you are so inclined, you could selectively consider bond funds at the shortest-maturity portion of the bond ladder.
4. In a moderate benchmark-rate environment in which spreads are at historically high levels, utilizing bond funds for the short- and intermediate-term exposure on the ladder seems acceptable. In this environment, favoring non-Treasury bonds is certainly worth considering.
5. In a high benchmark-rate environment in which spreads are at historically average or below-average levels, focus purchases on Treasuries and select individual non-Treasury bonds. In this environment, even those who typically favor short-term ladders should consider extending the maturity profile of the ladder.
6. In a high benchmark-rate environment in which spreads are at historically high levels, buy bonds across the board. This includes bond funds and individual bonds alike. In this environment, even those who typically favor short-term ladders should extend the maturity profile of the ladder in order to lock in favorable rates for longer periods of time.
What kind of environment are we in now? Unfortunately, using the scenarios outlined above, the answer is number one. Nowadays, if you are looking to build a bond ladder, you may want to familiarize yourself with my recent article, “4 Ways to Find ‘Real’ Yields in a Low Interest-Rate Environment.”
While I would overwhelmingly favor building a ladder with individual bonds in a low benchmark-rate environment in which spreads are at historically average or below-average levels, I understand there are those who want a more passive approach. Even though it will cost you a bit more to build a ladder with funds (comparing a discount bond broker’s commissions to the commissions and/or fund fees you would pay when buying funds), you will get a level of diversification that is likely far in excess of what you would get on your own. Essentially, by building a ladder with funds instead of individual bonds, you will trade yield for diversification. And if you go with non-defined maturity funds, you also run the risk of giving up some of your principal over the long run. If buying funds is a route you want to go, given today’s rate environment, I would certainly encourage a focus on defined-maturity funds over non-defined-maturity funds. And if you do buy a non-defined-maturity fund, make sure the duration is very low.
On a final note, if you do find your way to defined-maturity funds, keep in mind that the 30-day SEC yield and weighted average yield-to-worst advertised is not the same as the actual yield you will earn. Guggenheim Investments, which offers the Guggenheim BulletShares defined-maturity ETFs, has an “Estimated Net Acquisition Yield Calculator,” which every investor purchasing shares should use before entering a buy order. The calculator is found on the “Yields & Performance” pages of the various funds. Today’s 30-day SEC yields and weighted average yields-to-worst are quite different from the estimated net acquisition yields.
More from The Financial Lexicon:
Income Investing Insider Newsletter
The 5 Fundamentals of Building a Retirement Portfolio
Options Strategies Every Investor Should Know
Learn how to generate more income from your portfolio.
Get our free guide to income investing here.