Bond ladders for inflation and deflation
Financial advisers recently surveyed about fixed-income allocations indicated a continuing strong preference for municipal and corporate bonds.
Financial advisers recently surveyed about fixed-income allocations indicated a continuing strong preference for municipal and corporate bonds.
Among the seven asset classes listed, muni bond allocations ranked first in terms of “most likely to increase” during the next six months, with more than 65% of financial advisers saying that they expect to add to their muni bond portfolios in the near term. Investment-grade corporate bonds ranked second, with 62% of advisers expecting to increase their weighting to high-grade corporates.
Why are so many advisers and investors choosing muni and corporate bonds in the current interest rate environment? The conventional answers might include yield enhancement relative to U.S. Treasuries, reliable income and a high degree of principal security.
A less-often-cited reason for fixed-income securities is that laddered-bond portfolios can address both inflation and deflation concerns.
Deflationary pressures are on the minds of many fixed-income professionals, including Bill Gross of Pacific Investment Management Co. LLC, who observed that the United States may be “tipping toward deflation.”
He said recently: “Deflation isn’t just a topic of intellectual curiosity; it is happening,” citing an annualized 0.1% decline over the past two years in the U.S. consumer price index.
Although an extended period of deflation isn’t the most likely economic scenario, notable economists such as St. Louis Fed President James Bullard have warned of a Japan-like period of deflation and slow growth.
In a slow-growth and mild-deflation environment, intermediate and longer-dated muni and corporate bonds typically perform well. If inflation pressures return, short-dated bonds will roll off to allow reinvestment at higher rates.
When faced with the question of how best to own bonds, investment professionals often decide to build custom bond portfolios instead of paying fund or exchange-traded-fund management fees. The recent survey indicated that about 40% of the advisers surveyed favor individual bonds for fixed-income allocations, while 44% favor bond funds, and 16% favor bond ETFs.
Bond funds and ETFs have several potential advantages: instant diversification, the ability to trade easily and professional management. They are proven instruments that can add value, particularly for smaller portfolios.
However, if a fixed-income portfolio is more than $250,000, a custom portfolio could be a good choice. And if the portfolio has at least 10 to 15 issues of highly rated bonds, it may be sufficiently diversified.
An interesting option for laddering bonds is a “hybrid barbell” approach, which essentially comprises two ladders.
A “liquidity generator” in the short end could be made up of a one to five-year ladder with sequential six-month final maturities. This short ladder is designed to create fresh principal in a perceived “rich” short-term market, with an expectation for reinvestment at higher rates in an inflationary environment.
The second ladder could be an income or “yield generator” that focuses on 10- to 20-year maturities in which higher yields are available. Taken together, this hybrid ladder addresses liquidity needs while still benefiting from the relative value further out on the yield curve.
Naturally, there is credit risk to be considered, and sufficient time must be allotted to determine the creditworthiness of each holding.
The probability of default among the vast majority of muni bonds is very low. However, the default risk may rise in localities with high jobless rates, foreclosures, lower home values and slowing retail sales — all of which constrict state and local tax revenue.
Likewise, while the default risk of investment-grade corporate bonds is historically low, it isn’t insignificant. Bond funds and ETFs are diversified to address this risk, and well-managed portfolios of individual bonds can achieve the same objective.
Custom-built laddered portfolios of new-issue and secondary muni and corporate bonds have numerous advantages. These include defined maturity and interest payment schedules, control over which bonds are held, and tax-efficiency.
New-issue bonds can further simplify the process of owning individual securities, with clear pricing and tax consequences.
John Radtke is the president of Incapital LLC, a securities and investment-banking firm.
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