Is Bond Laddering The Strategic Answer To Rising Rates?

With the Fed indicating that further rate hikes might be in the offing before the end of the year, it might be time for income investors to begin positioning their portfolios accordingly. The Fed futures market is still indicating a roughly 50-50 chance of a rate hike before the end of the year, but interest rates have already slowly ticked up over the past couple of months. The 10-year Treasury hit a near-term bottom of around 1.35% in early July, but currently sits about 20 basis points above that level.

The price/yield relationship of bonds is well known, so investors reaching into longer-term bonds and Treasuries for yield should start thinking about defensive strategies to protect themselves from rising rates. The path to higher rates will likely be slow and deliberate, so an aggressive move to the short end of the curve probably isn’t the best strategy, but investors will also want to aim for as much flexibility as possible in case the market moves more quickly than anticipated.

Bond laddering could be a strategy that addresses the need for maximizing both yield and flexibility.

For those unfamiliar, laddering involves holding bonds of various maturities and reinvesting the proceeds of maturing securities back into longer-term issues. The primary advantage in a rising rate environment is that bonds with lower yields are continuously being reinvested into higher rate notes.

Investors looking to implement a laddered bond strategy for their own portfolios have options in investment grade corporate bonds, high yield corporate bonds and munis.

iShares, and its iBonds ETF group, offer 10 different corporate bond ETFs with maturities going all the way out to 2025 (IBDF, IBDJ, IBDH, IBDK, IBDL, IBDM, IBDN, IBDO, IBDP, and IBDQ). Its muni bond group includes annual maturities up to 2022 (IBME, IBMF, IBMG, IBMH, IBMI, IBMJ, and IBMK).

The other big player in the laddered bond area is Guggenheim through its BulletShares ETF family. It has offerings in both corporate bonds through 2025 (BSCG, BSCH, BSCI, BSCJ, BSCK, BSCL, BSCM, BSCN, BSCO, and BSCP) and high yield bond funds through 2023 (BSJG, BSJH, BSJI, BSJJ, BSJK, BSJL, BSJM, and BSJN).

Combined, the two companies manage more than $10 billion in laddered bond ETFs.

Advantages of Laddering

When it comes to fixed income, it’s usually better to invest through ETFs. Many don’t have the resources to achieve proper diversification through individual notes and increasing default risk could quickly damage any bond portfolio. Both S&P and Fitch have raised their high yield default forecasts for 2017 to the 5-6% range with the energy sector looking at default rates up to 20%. Increasing rate and default risks in fixed income mean many investors are better off leaving their bond portfolios in the hands of the pros.

Laddered ETFs can also serve investors with specific investment goals better than generic bond funds. Much like target-date funds, a bond ladder can produce a fixed income portfolio where specific maturity date risk can be minimized while the portfolio becomes more conservative as time passes. Whereas generic bond funds have average maturities that generally remain within a range, laddered bond ETFs provide a very specific target maturity that can help manage overall portfolio risk.

Disadvantages of Laddering

One of the downsides of laddered bond ETF strategies is that they require work. Money invested in a fund whose assets are maturing is not automatically rolled over into a fund with a longer maturity. As maturity approaches, cash proceeds remain invested in the fund until the ETF is liquidated altogether and proceeds distributed to shareholders. Investors need to actively oversee their portfolios in order to reinvest maturing funds or decide on another strategy altogether.

Costs can also be an issue with laddered bond funds. iShares corporate bond ETFs mostly have expense ratios of 0.10% while its muni bond funds are at around 0.18%. Guggenheim has higher expense ratios with its investment grade corporate funds around 0.24% and its high yield funds at 0.42%. Low interest rates on fixed income securities mean that any portfolio management fee can make a big difference. In the case of the Guggenheim BulletShares 2016 Corporate Bond ETF, its 30-day yield is just 0.62%. With an expense ratio of 0.24%, more than one-third of the fund’s yield is offset by fund expenses.

Daily volumes on these ETFs can also be very low adding to the fund’s costs via potentially high bid/ask spreads.

Conclusion

The bond laddering strategy is a sound one, but the costs of implementing such a strategy, especially on the short end of the curve, can negate much of the benefits. This is especially the case for the iShares muni bond ETFs. Its longest-term muni fund, the 2022 Muni Bond ETF, offers a yield of just over 1%. This means that nearly 20% of the fund’s yield is going towards expenses and, in case of the shorter maturity funds, sometimes much more.

iShares is the lower cost provider of the two, which probably makes it the better choice on the investment grade corporate bond front. Its 0.10% expense ratio is reasonable and is about as good as one can do for a passively managed fixed income fund. Despite higher expense ratios, the Guggenheim high yield ETFs may still make sense. From a cost and diversification standpoint, most investors will benefit from a fund manager constructing a junk bond portfolio in order to minimize default risks.

For less sophisticated investors, the additional portfolio oversight needed to successfully institute a laddered strategy may prove too daunting. Bond laddering may prove more appropriate for seasoned investors willing to actively manage their portfolios as long as costs don’t become counterproductive to the strategy.

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