Bond ladders can be rickety at times. But they may provide protection against volatile interest rates and offer ways to capture higher yields as they hit the market.
The concept is straightforward: Assemble a portfolio of individual bonds or funds that mature at regular intervals and reinvest the principal in a new longer-term holding when the nearest-term bond matures.
The market looks appealing for ladders. The Federal Reserve is likely to push up yields at the short end of the curve through mid-2023. That should benefit laddered portfolios since their short-term holdings would quickly roll off, providing principal to reinvest at higher market yields.
“The simplicity of laddered portfolios works well in this market,” says Nisha Patel, who oversees separate account portfolio management at Parametric, part of Morgan Stanley Investment Management.
Yields at the short end are looking far more attractive than those at the long. A six-month Treasury yields 4.7%, for instance. That’s well above the 10-year yield at 3.7%, making it sensible to focus a ladder on short-term paper at the moment.
Indeed, ladders can be fairly short, extending out just three years. In that scenario, a third of the portfolio would roll off every year.
With longer-dated bonds, investors “pick up very little yield, but they massively increase their volatility and duration risk,” said Jason Bloom, head of fixed income and alternatives ETFs at Invesco. Duration is a bond’s sensitivity to changes in rates.
A ladder can be built with individual bonds, but it isn’t as simple as using exchange-traded funds, which handle the security selection, credit analysis, and trading. “With individual bonds, it can be a hefty task,” says Saraja Samant a fixed-income strategist at Morningstar.
Both iShares, through its iBonds ETFs, and Invesco, with its BulletShares suite, offer ETFs that can be used to construct a ladder. These funds hold bonds that all mature in a certain year. They distribute interest regularly and make a final payout at the stated year of maturity for all of the bonds in the portfolio.
Investors also can use these ETFs to build a laddered portfolio of different bond categories, including corporate, high-yield, municipal, emerging market, and Treasury debt.
Granted, ladders won’t prevent losses if rates rise sharply. Duration risk still matters quite a bit. “Bond prices will drop in real time as interest rates go up,” says Bloom. “But if you hold a bond to maturity and it does not default, you’ll get the return you bargained for when you bought it.”
That’s an important consideration for ladders to work effectively.
Invesco BulletShares 2027 Corporate Bond
ETF (ticker: BSCR) is down 10% this year, including interest, compared with a 0.6% gain for the corresponding ETF that matures in December.
One way to avoid losses may be to hold the ETFs to maturity. If, for example, an investor sold the 2027 corporate-bond ETF, it would bring a loss for that holding. But the ETF’s net asset value should get back to par in 2027 when its bonds mature. Investors can avoid a loss of principal by holding the fund until then.
|Fund / Ticker||30-Day SEC Yield||AUM (bil)||YTD Total Return||Expense Ratio|
|iShares iBonds Dec 2023 Term Treasury ETF/IBTD||4.37%||$1.7||-2.0%||0.07%|
|Invesco BulletShares 2023 Corporate Bond ETF/BSCN||4.88||2.6||-1.3||0.10|
|iShares iBonds Dec 2024 Term Treasury ETF/IBTE||4.55||1.2||-5.0||0.07|
|Invesco BulletShares 2024 Corporate Bond ETF/BSCO||5.25||3.5||-4.7||0.10|
|iShares iBonds Dec 2025 Term Treasury ETF/IBTF||4.30||724 million||-7.0||0.07|
|Invesco BulletShares 2025 Corporate Bond ETF/BSCP||5.26||1.8||-6.5||0.10|
Returns, AUM and expense ratios as of Nov. 21. iShares 30-day SEC yields are as of Nov. 18; those from BulletShares are as of Nov. 21.
Sources: Morningstar and company websites.
How do you build a ladder? Keep it simple. An example is an equal-weighted three-year ladder that uses high-quality corporate-bond ETFs, maturing in 2023, 2024, and 2025. A ladder combining those three BulletShares ETFs would yield 5.12% and have a duration of 1.45 years.
An investor could take the proceeds from the ETF that expires in 2023 and reinvest them in an ETF maturing in, say, 2026. That would maintain the portfolio’s three-year life span. If rates keep rising, the investor could pick up a higher yield. One could also adjust credit risk—say, with higher-yielding corporates or Treasuries.
One consideration is what might happen if the Fed stops tightening and market yields start to fall. The risk then is that investors will have to reinvest proceeds from a maturing bond or ETF into lower-yielding securities.
Investors would still own some longer-maturity bonds that yield more than newly issued debt, notes Samant. As yields decline, bonds could also generate capital appreciation, since prices rise as yields fall.
Another risk, primarily in the muni and high-yield “junk” spaces, is callable bonds. Issuers can redeem these securities at a specified date and would have incentives to do so if rates are falling. Bondholders would then face reinvestment risk. Callable features are rare in investment-grade corporate bonds, though they’re more prevalent in high-yield and munis, says Bloom.
If a bond is called, BulletShares puts the proceeds into 13-week Treasury bills until the ETF is rebalanced the next month. That’s also when the called bond is replaced by another corporate issue.
One way to avoid call risk is to focus on Treasury ETFs, says Samant. Treasuries pose no credit risk, though they are highly sensitive to rates.
Bond ladders work best for investors who don’t worry so much about market gyrations, says Dan Genter, CEO of Genter Capital Management, which offers muni ladders. “They’re suitable for someone who says, ‘All I care about is getting income; I don’t really care if it goes up or down, as long as my principal is safe,’ ” he says.
Bond ETFs maturing in the next few years now offer a smattering of appealing yields, including 4.88% in
Invesco BulletShares 2023 Corporate Bond
ETF (BSCN) and 8.6% in
As long as you don’t fall off the ladder and sell before the ETFs mature, you should recoup your capital to invest for another day.
Write to Lawrence C. Strauss at [email protected]
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