Other proponents, however, stick to the idea that today's steeper yield curve serves the goals of bond laddering best. "In a flattening yield curve, there are other strategies that would outperform the bond ladder," says George Strickland, managing director and portfolio manager with Thornburg Investment Management in Santa Fe, N.M.
How It Works
Bond laddering is pretty straightforward to implement. You populate the rungs of the ladder with issues all along the yield curve.
For example, if you have a $1 million ladder to build, you might purchase 10 rungs of $100,000 in each of 10 years, starting with one-year certificates of deposit and one bond in each of the next nine years. As one issue comes due each year, you purchase a new 10-year note, in this example. Of course, it is possible to build the ladder with bonds of different maturities or to emphasize the short end or the long end, depending on the client's needs or your interest rate forecast.
The ladder achieves several goals. First, it provides a predictable income source. Second, it gives a bond portfolio a shorter average maturity, but with almost the same yield as a longer maturity one. In the above example, the average maturity of the portfolio would be five years.
That mismatch between maturity and yield helps to mitigate both interest rate risk and reinvestment risk. Bond ladder investors are not tied into lower yielding fare for long should yields rise, nor are they forced to purchase an entire portfolio of crummy coupons should rates fall. "Over time, you are able to pick up the yield of a 10-year bond with the volatility and risk of a five-year bond," Strickland says.
Construction Ahead
Speak with a few money managers, and you'll see that the number of bond ladder strategies is as varied as the number of managers. Some advisors prefer to use Treasuries, others like munis and still others might sprinkle in a few corporate bonds for added yield.
Bert Whitehead, founder of Cambridge Advisors and author of Why Smart People Do Stupid Things with Money, designs his ladders going out 15 years using Treasury separate trading of registered interest and principal securities, better known as STRIPS. Bondholders purchase the bonds at a steep discount because the bonds mature at par.
At maturity, Whitehead uses the proceeds for client income, rather than reinvesting in a new bond. He buys new bonds for the ladder with money from clients' stock portfolios. This way, he says, clients are assured of income for 15 years. "We rebuild the bond ladder during times of prosperity," he says.
When times aren't as good, like right now, clients' cash flows aren't affected because it comes from the ladder. "Cash flow is always cash flow," he says.
The bond ladder represents about 40% to 50% of a client's investable assets, with roughly 50% in stocks and the remainder in cash. The dependable income from the bond ladder allows Whitehead's clients to take more risk in their equity portfolios than they normally would be able to tolerate in retirement.
Whitehead begins building the retirement bond ladder when clients are still in their forties and fifties. "We dollar cost average into interest rates," he says. It takes that long for the maturing bonds to become available as income, as well.
Then there are advisors like Johnson, who says he can "usually implement a good ladder over a number of days." Johnson uses the more conventional approach of reinvesting maturing bonds in long-dated bonds. And he uses straight Treasuries and Treasury Inflation Protected Securities, or TIPS.
In the middle are advisors like Shane Merritt, a financial advisor with Merritt Capital Management in Gloucester, Mass., who takes six months to pick and choose the types of bonds he wants to build into clients' bond ladders. Merritt, whose firm offers advisory services through Raymond James Financial Services, even includes corporate bonds on his ladder rungs.
Yet most advisors agree that ladders with small dollar amounts—less than $250,000—won't give clients proper diversification. Most bonds sell in minimum lots of $10,000, so a portfolio of 25 issues can diversify the bond ladder along issuers, structures and interest rates.
What's in There?
What types of bonds belong in a bond ladder? Again, there are as many answers to that question as there are advisors, and it all depends on the client's individual situation.
Some ladder builders insist that any investment vehicle riskier than Treasury bonds doesn't belong and won't give retirees the type of ironclad income they need. Defaults are worrisome in any portfolio, but they are particularly difficult to stomach in one whose main purpose is income generation. "Return on your principal is important, of course, but we also focus on return of your principal," Johnson explains.
With such low rates on Treasuries today, those returns aren't going to allow most retirees to live high on the hog, Johnson concedes. These days, he and other advisors favor municipal bonds for the ladder. Not only are the yields tax-free, which can be especially important if the bond ladder isn't in a qualified account, but yields on triple-A credits far exceed those of Treasury bonds, a highly unusual occurrence.
As of January, the average triple-A-rated municipal bond maturing in 10 years had a 3.68% yield vs. 2.28% for a comparably dated Treasury. At these rates, Richelson says, a muni bond ladder is even appropriate in a qualified account because of the yield bonus relative to Treasuries.
Even if munis aren't quite as safe as government bonds, and municipal budgets are strained in this recession, their yields warrant a look. "Certainly municipal bonds have more credit risk than before, but are you really worried that the state of Virginia is going to blow away like Enron?" Richelson asks.
Advisors like Merritt go even further on the credit risk spectrum by placing corporate bonds in the bond ladder. Defaults are much higher among corporate bonds than they are with municipals, but he believes investors get paid handsomely to take those extra risks.
Merritt's approach is not for everyone, the advisor acknowledges. "It really depends on the client and his or her risk tolerance," he says. "In a bond ladder, you can use anything that pays a fixed income and has a maturity date." Merritt even uses preferred stocks, which are hybrids of bonds and stocks.
Interest Rate Concerns
The biggest concern for bondholders is rising interest rates, which usually result from higher inflation. Higher rates reduce the value of older, lower-yielding bonds, so their prices fall. In bond mutual funds, this price depreciation is reflected immediately because the bonds in the fund are repriced daily.
But investors holding individual bond issues directly do not need to suffer price declines if interest rates rise. If the bond is held until maturity, principal is paid back at par. A bond ladder can reduce some of this worry, and investors owning ladders can even benefit from rising interest rates, advisors say.
"If people are more concerned about preserving their income and less concerned about what happens to prices in between, I would say target longer strategies," says Strickland, who co-manages the Thornburg Strategic Income fund, which practices bond laddering. An investor can buy bonds at the new higher rate with the proceeds of bonds rolling over.
In fact, lower interest rates—and the price appreciation they lead to—can actually do more harm than good to a bond ladder. When old bonds mature, the options for reinvestment are not as favorable as they were before. However, a fund using a bond ladder strategy can profit from this situation, Strickland says.
"In a falling interest rate environment, your bonds would be marked up in price, so you could have some short-term price appreciation," Strickland explains. In his fund, Strickland uses times of falling rates to sell some of the fund's holdings to add to its total return.
For individuals, fortunately, the entire bond ladder does not have to be reinvested all at once, so the deteriorating yield is gradual. Eventually the falling rates may reverse.
Curve Getting Steeper
It has become clear that long rates remained stubbornly low despite a program of rate hikes on the short end by the Federal Reserve starting in 2004, due to the financial system's massive leverage. As the process of deleveraging began, the yield curve returned to its normal steep shape, with longer-dated bonds yielding more than those maturing in just a few years.
Most practitioners believe that bond ladders should invest in the different maturities equally, but Richelson isn't one of them. He believes higher yields on the long end can help advisors put some strategies in place. "The yields get higher and higher as you pass 10 years," he says. "I could go 15 to 20 years and take advantage of those high yields as my money comes due on the short end. I can even sell the short end of my ladder."
Even if the yield curve is steep, other advisors like Merritt aren't so quick to tie up money on the long end. With so much government borrowing needed to finance the numerous bailout packages, inflation is likely to follow, he reasons. That will inevitably drive up interest rates.
Merritt is hesitant to tie up clients' assets on the long end of the bond ladder if higher rates are coming. "We are likely to see rising inflation in the next few years," he predicts. "If that's the case, then the structure of the ladder is going to look very different from where it stands today." Thus, Merritt has front-loaded his bond ladders with bonds maturing in the five- to seven- year range.
Whatever shape the yield curve may take in the future and whatever direction interest rates may move in, clients with bond ladders have options to ensure that they will enjoy a steady stream of income in retirement. Advisors know that a bond laddering strategy can go a long way to provide these clients with peace of mind—a rare commodity in today's turbulent markets. FP
Ilana Polyak is a New York-based freelance writer. She contributes frequently to Financial Planning.
