Outside-IN

Outside-INblog

Outside voices and views for advisers

The downsides of laddered bond portfolios

Why bond laddering isn't the solution to a rising rate environment

Jul 15, 2014 @ 7:13 am

By Terry Hults

We think investors who build laddered portfolios to protect against rising rates will be disappointed — by locking in low yields with traditional ladders or by hidden risks of higher-yielding ladders. In our view, actively managed portfolios are better able to take advantage of changing markets.

Laddered portfolios are built with bonds spaced evenly across maturities so that bonds mature and their proceeds are reinvested at regular intervals. These portfolios are assumed to be simple, provide return certainty and capture higher yields as interest rates rise.

They're definitely simple, and they do provide a relatively certain return. But in today's low-yield environment, that return is likely to be locked in at below-inflation yields for the next few years. A portfolio laddered from one to 10 years yields only about 1.5 percent before accounting for the costs of trading and other annual fees. At that low yield, there's little chance to beat even a modest rate of inflation.

To improve yield in a low-rate environment, laddered portfolios sometimes include longer-maturity bonds, which increase their interest-rate risk; or portfolios include lower-credit-quality bonds, which increase credit risk. In our view, neither approach is advisable in a passive portfolio. Putting money into the riskiest parts of the bond market, without the ability to monitor and manage those risks, jeopardizes the value of what investors often consider the safest part of their portfolio.

Another way laddered portfolios sometimes seek to boost yield is by eliminating short-term maturities — shifting to a five- to 15-year ladder, for example. However, this strategy virtually eliminates the benefits of reinvesting when rates rise: Investors have to wait five years until the shortest bond matures before reinvesting. In effect, it puts the portfolio on hold for five years.

Yield Isn't the Only Source of Return for Actively Managed Portfolios

When interest rates rise, a passively managed laddered portfolio has to wait until a bond matures to reposition and capture higher yields. In a 10-year ladder, for example, the investor owns a 10-year bond, a nine-year bond and so on, all the way down to a one-year bond. When the one-year bond matures, the investor can buy a new 10-year bond. But until that one-year bond matures, the only thing to do is wait—and maybe miss out on taking advantage of interest-rate fluctuations in the meantime.

While a laddered portfolio's return comes largely from yield, actively managed portfolios can access other sources of return. Given today's steep yield curve, returns can be bolstered with “roll” — he tendency of bonds' values to increase as they move closer to their maturity date. Active managers can seek to profit by buying bonds with high roll returns and selling other bonds whose values are likely to fall as they approach maturity. Right now, the potential return from roll in the intermediate part of the yield curve seems especially high — in some cases, adding almost 2 percent to a bond's additional return potential above its yield.

The simplicity of laddered portfolios is appealing. Unfortunately, in return for simplicity, an investor either 1) locks in historically low yields and is likely to lose money after accounting for inflation over the next couple of years; or 2) increases his yield and takes on risks that should be actively managed.

In the end, we think investors can earn more after-tax income and total return by stepping off the bond ladder and placing their bond portfolios in the hands of an experienced active manager.

Terry Hults is a portfolio manager, municipal investments at AllianceBernstein

The views expressed herein do not constitute research, tax advice, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. Past performance of the asset classes discussed in this article does not guarantee future results.

0
Comments

What do you think?

View comments

Recommended for you

Sponsored financial news

Upcoming Event

Mar 13

Conference

WOMEN to WATCH

InvestmentNews is honoring female financial advisers and industry executives who are distinguished leaders at their firms. These women have advanced the business of providing advice through their passion, creativity, inclusive approach and... Learn more

Featured video

INTV

Why some retirement plan advisers think Fidelity is invading their turf

InvestmentNews editor Frederick P. Gabriel Jr. and reporter Greg Iacurci talk about this week's cover story that looks at whether Fidelity Investments is stepping on the toes of retirement plan advisers.

Latest news & opinion

Is Fidelity competing with retirement plan advisers?

As the Boston-based mutual fund giant expands the products and services it brings to the retirement market, some financial advisers say the firm is encroaching on their turf.

Gun violence hits investment strategies, sparks political debates with advisers

Screening out weapons companies has limited downside.

Whistleblower said to collect $30 million in JPMorgan case

The bank did not properly disclose that it was steering asset-management customers into investments that would be profitable for JPMorgan Chase.

Social Security underpaid 82% of dually entitled widows and widowers

Agency failed to tell survivors that they could switch to a higher retirement benefit later.

If Finra eases firm oversight of outside business activities, broker-dealers could lose revenue

Brokerage firms would no longer be able to charge reps for supervising nonaffiliated RIAs.

X

Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting investmentnews.com? It'll help us continue to serve you.

Yes, show me how to whitelist investmentnews.com

Ad blocker detected. Please whitelist us or give premium a try.

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print