INSIGHTS

On June 05, 2017

AAM Viewpoints – Bond Ladders: An Oldie but Goodie

While investment fads tend to come and go, one strategy that has had remarkable staying power is the bond ladder. Laddering bonds is a methodology that is especially useful for investors looking to own a portfolio of individual bonds and has garnered recent attention as investors grapple with how to approach low bond yields and an expectation that higher rates are on the horizon. Concerns about the effects of potential rate increases have led many to look to individual bonds and professional management, in the form of Separately Managed Accounts (SMA), in an effort to customize and control interest rate and credit exposures within portfolios. While this has resulted in renewed interest in laddering bonds, the reality is the strategy has been employed through bear and bull bond markets and will likely continue to be the foundation for many fixed income management philosophies.

A bond ladder is a portfolio of individual fixed income securities with the maturities staggered across a given timeframe to gain exposure to several different points along a yield curve. For instance, a 10-year bond ladder would carry maturities at each “ladder rung” from year one through year 10. It is important to understand the purpose of a bond ladder as it relates to the various risks associated with an investment in individual bonds. All fixed income, with the exception of U.S. Treasuries, carry both credit and interest rate risk. Credit risk refers to the risk that an issuer defaults and the investor loses principal. Credit risk drives a bond’s price through the widening and narrowing of credit spreads as the perceived credit risk increases or decreases. It is important to note that a bond laddering strategy does nothing to address, offset or otherwise insulate a portfolio from credit risk. Rigorous credit work is still required to ensure that credit risk exposures reflect a given investor’s risk tolerance. On the other hand, bond laddering is the most tried and true method to reduce interest rate risk within a fixed income portfolio. Interest rate risk is the effect on portfolio valuations due to changing interest rates and includes the effect of changing rates on opportunities for reinvestment. As interest rates increase bond prices fall, and as interest rates decrease bond prices increase. The magnitude of the price change for a given move in interest rates is interest rate risk and can be addressed with a laddering strategy.

Laddering bonds helps reduce interest rate risk through the diversification of interest rate exposures. It operates on the same principle as equity diversification or diversifying credit risk. By placing monies at each rung in a laddered structure you are minimizing, or smoothing, the volatility created by a move up or move down in rates at a specific point on the yield curve. Since the magnitude of most interest rate moves, regardless of direction, tends to be different at different points along a yield curve, where and how you position a portfolio from an interest rate risk standpoint can have a drastic effect on portfolio performance. For instance, a portfolio with a large allocation to short-term bonds will be impacted by an increase in short-term rates to a much greater extent than a portfolio with a large allocation to longer-term bonds if short-term rates rise faster than long-term rates. By diversifying interest rate exposure amongst many points along a yield curve we can minimize, as much as possible, interest rate changes at any single tenor.

Bond ladders also provide a mechanism to help maximize portfolio income and return especially in the context of a rising rate environment. Falling bond prices in a rising rate environment reflect opportunity costs. These opportunity costs represent reinvestment risk. Since longer-dated bonds tend to be more sensitive to rising rates than shorter-term bonds, investors locked into longer-dated bonds when rates move up typically forgo the opportunity to reinvest at higher rates without incurring principal losses. A bond ladder structure helps reduce the impact of these opportunity costs by allocating amongst many maturities including on the shorter end of the yield curve. As rates move up these shorter-term positions mature or can be sold with minimal risk to principal allowing for reinvestment at higher rates on the longer end of the ladder. The mitigation of reinvestment rate risk is the cornerstone of the bond ladder strategy and generally results in predictable cash flows and the ability to take advantage of changing interest rate environments.

Most bond managers, especially those managing tax-exempt strategies, tend to utilize bond laddering methodology in some form or fashion. The traditional bond ladder model is typically looked at as a buy-and-hold structure; however, the addition of active management allows for the construction of “enhanced” customized bond ladders. Robust credit work can help to generate risk-adjusted returns, allowing for credit risk diversification and portfolio construction with credit risk exposure tailored to specific client risk tolerances. In addition, actively searching for opportunities to swap bonds, while staying within the confines of the laddered bond structure, has the potential to reap the benefits of interest rate and reinvestment risk reduction while providing potential opportunities to enhance returns. When considering how to structure portfolios with an eye toward the reduction of interest rate risk, we believe it is beneficial to not overlook this oldie but goodie as a possible solution. 

CRN: 2017-0605-5990R