Bond ladders for fans of portfolio safety

Proponents of the strategy tout its effectiveness in any rate environment

May 11, 2014 @ 12:01 am

By Jeff Benjamin

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"When it comes to fixed income, we believe that safety always trumps yield." - Bert Whitehead, Founder, Cambridge Connection and Alliance of Cambridge Advisors

While it might be tempting to start finagling with fixed-income allocations as the next rising-interest-rate cycle draws nearer, proponents of bond ladders say the tried-and-true strategy works in all cycles if safety is your guide.

"When it comes to fixed income, we believe that safety always trumps yield, and going for more yield always compromises safety," said Bert Whitehead, founder of Cambridge Connection Inc. and Alliance of Cambridge Advisors Inc.

Building a portfolio of bonds that are set to mature at regular intervals over a 10-to-15-year period and holding them to maturity is the surest way to provide clients with a steady and predictable income stream in retirement, according to Mr. Whitehead.

In the bond-ladder space, Mr. Whitehead would be considered a purist, using only zero-coupon U.S. Treasury bonds.

"With any other type of bond, aside from Treasuries, the additional yield you get never covers the additional risk you are taking," he said. "Treasuries are plain vanilla at the top of the heap and they can't be called, and the safety they provide allows you to take more risk in the stock portion of the portfolio."

While most bond-ladder believers are constructing them for clients to help avoid the risk facing most traditional bond mutual funds in a rising-rate environment, the pure Treasury route is not for everyone.

NO 'PURIST APPROACH'

"We don't have a purist approach to the ladder because Treasuries are just not worth it when we're looking at the risk versus the reward," said Carolyn McClanahan, director of financial planning at Life Planning Partners Inc.

She relies mostly on investment-grade municipal and corporate bonds for ladder rungs.

"For us, it's all about the yield curve, and right now most of what we're buying for ladders is between seven and 10 years [maturity]," Ms. McClanahan said. "When I started doing this back in 2005, when rates were more favorable, we were grateful we went out so far [on the yield curve] with our ladders, but we're not going out as far now because rates are still low."

With the Federal Reserve already winding down its quantitative-easing program and making public its plans to start raising short-term interest rates sometime next year, the case for bond laddering should be clear, according to J. Brent Burns, president of Asset Dedication.

"A rising-rate environment is when bond ladders are designed to shine," he said. "When rates are flat or rising you have control over how far out on the yield curve you want to go, but you do need to be comfortable knowing that rates could rise."

The issue of rising rates in a bond ladder is largely psychological, because the strategy is designed to hold all bonds to maturity and any new bond purchased when an older one matures should come with higher yields. The biggest risk comes if an investor or adviser tries to time the rate cycle by holding off on purchases of new rungs in the ladder until rates are higher.

RISING RATES

Since interest rates have been generally trending down for more than 30 years, most financial advisers haven't had to deal with the challenges of building bond ladders in an extended rising-rate cycle.

But, as Mr. Burns explained, it will be easier to buy ladder rungs accepting the chances of rates moving higher, than it was to hold onto bonds as rates were falling, which constantly drove up the values of the bonds.

As for the matter of employing corporate or municipal bonds versus using Treasuries for bond ladders, Mr. Burns tends to lean in the direction of the purist camp.

"We don't buy bonds for years like 2013, we buy bonds for years like 2008, and the problem is you never know when a year like 2008 is coming," he said. "If the bond ladder is being created for somebody who needs that paycheck, then I'm less comfortable using corporate bonds where you could end up with something like a Lehman Brothers scenario."

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