Rising Interest Rates Make Bond Ladder ETFs More Appealing

Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. A silver lining has emerged as interest rates rise. We’ll explain how bond investors can benefit. Plus, a few ideas on how to hedge your portfolio against high inflation. And Disney wrapped up its fiscal year with wins and losses. Find out whether our team thinks the stock is a buy or not. This is Investing Insights. Welcome to Investing Insights. I’m your host, Ivanna Hampton. Let’s get started with a look at the Morningstar headlines.

Disney Loses Some Magic as 2022 Ends

Disney reported a mixed end to fiscal 2022. The company had impressive streaming growth, as well as record parks revenue, but a much larger loss at the media division. Losses widened greatly at the direct-to-consumer segment. Management claims that the fourth quarter represents the peak losses for that segment. And business is still expected to achieve profitability in fiscal 2024. But it also made mention of no meaningful shift in the economic climate. Disney-Plus added more than 12 million customers globally in the quarter versus less than two-and-a-half million for Netflix. The growth was more evenly spread than last quarter among the different global markets. Morningstar Research Services’ senior equity analyst Neil Macker lowered his estimate of what he thinks Disney’s stock is worth to 170-dollars. He believes the shares are significantly undervalued.

Roblox Has Mixed Messages in Q3

Positive and negative news came out of Roblox’s third-quarter results. The video game platform saw user growth and more bookings – but the operating loss widened significantly compared to last year. Global daily active users were almost 59 million. That is 11 million more users than they had a year ago. The reach with older gamers continued to improve. Meanwhile, profitability continued to fall short of Morningstar's projections due to the investment in headcount, spending on safety measures, and increased developer payouts. We'd projected the pace of hiring to slow. However, management expects to continue hiring through 2023, bucking the overall tech trend toward large-scale layoffs. We're lowering our estimate of what we think the stock is worth by $10 to $65. That’s to account for slower margin expansion and currency headwinds. We expect the stock to remain highly volatile.

Lyft’s Ride to Disappointment

Lyft's mixed third-quarter results and fourth-quarter outlook were disappointing. However, Morningstar continues to see strength in the ride-sharing giant’s network effect. A network effect occurs when more people use a good or service leading to an increase in value. Lyft’s network effect has driven growth in rider monetization. We're also pleased with the company's latest cost-cutting measures, though we still expect lower 2024 adjusted EBITDA—a widely used measure of corporate profitability. We've lowered our revenue growth assumption for this year through 20-26 because of ongoing uncertainty regarding the macro environment. We think Lyft will remain the second-largest ride sharing platform in the U.S. But we're now assuming Uber will slightly increase its market share over Lyft over the next few years. We've lowered our estimate of what we think the stock's worth from $65 to $55.We see the shares as deeply undervalued.

Bond-Ladder ETFs

Rising interest rates have pushed down bond prices this year. But there is a silver lining. Bond prices and yields move in opposite directions. And bond yields are higher than they were last year. As interest rates rise, some investors may benefit from building a bond ladder. Morningstar Research Services’ manager research analyst Saraja Samant has recently written about bond ladder ETFs.

Saraja, what's a traditional bond ladder and how does it work?

Saraja Samant:

Yeah. A traditional bond ladder involves a portfolio of individual bonds that mature at regular intervals. So once the nearest bond matures, the principle from that bond is reinvested in a new longer-term bond and the cycle continues. So now if you assume an upward-sloping yield curve, which technically means that bonds with longer majorities will have higher yield to compensate for the risk, if you plot this particular portfolio on a graph with, say, interest rates on the Y axis and maturity on the X, it would look like a ladder, hence the word bond ladder.

Hampton:

What are some of the advantages and disadvantages of building a bond ladder with individual bonds?

Samant:

Just like any strategy, this particular strategy has advantages and disadvantages. To start off with the advantages: It can help mitigate the interest-rate volatility. So, say, in a rising-rate environment, an individual investor will hold the bond until maturity to get back to principle and will now have a chance to reinvest that principle in the then-prevailing higher rates.

Similarly, if the interest rates are falling, and if the investor still decides to continue with the bond ladder, although he'll have to reinvest the proceeds from the maturing bond in a now-lower prevailing interest rate, he would still have the bonds from the previous investment still accompanied at a higher rate.

Thirdly, it gives a steady source of income from interest payments that these ladders give out. An investor can plan how they want to invest in these ladders and use these maturing proceeds to actually meet their liabilities.

Now to start with the disadvantages: Bonds do have a default risk. A bond ladder will work efficiently only if the bonds in the portfolio don't default. Also, for individual investors, this can turn out to be a costly affair because of the higher purchase minimums for these individual bonds than the transaction costs and the research costs. Thirdly, it is less diversification because you're buying individual bonds in the portfolio, which could increase the discovery default. And lastly, inflation risk. Inflation can erode the purchasing power of an investor if the bond ladder yields lower than the expected inflation in the market.

Hampton:

You've recently written about defined-maturity ETFs, and investors can use them to build an ETF bond ladder. What makes defined-maturity ETFs different? Can you give us an example?

Samant:

A typical bond fund holds bonds with a range of maturities in the portfolio and will trade in and out of these bonds within the portfolio to maintain a particular overall duration within the desired range. But a defined-maturity ETF tries to mimic the behavior of an individual bond. So, just like individual bonds, the ETFs will have a predefined maturity date. It does this by buying bonds that mature in a particular year in which the ETF terminates.

Thus, similar to an individual bond: As the ETF nears its maturity, its duration starts decreasing and so does its sensitivity to interest rates. And this is because the lower duration of the bond, lower is its sensitivity to interest rate.

To give you an example, take the iShares Core US Aggregate Bond ETF, which is basically an investable form to invest in the Bloomberg Agg. It has an effective duration of 6.3 years today. So, a 1% rise in rates would mean a 6.3% drop in its price. While the BulletShares 2022 Corporate Bond Defined-Majority ETF, today has a duration of 0.17 years, and that is because it has neared its maturity. Previously, when it was launched in 2013, it had a duration of 7.4 years.

What these defined-maturity ETFs basically do is hold a number of bonds in the portfolio, thus provide you a diversification, but at the same time, they try to mimic the behavior of individual bonds.

Hampton:

Well, you talked about traditional bond ladder disadvantages. What are some of the risks associated with bond ETFs?

Samant:

There are some risks that can arise while investing in these defined-maturity ETFs. Unlike individual bonds, they do not guarantee the principle back. So, when these ETFs mature, they will pay the investor back their money at the closing net asset value, that is, the NAV.

Secondly, unlike individual bonds, the ETFs don't have a predefined coupon rate, and thus the distributions through the life of these ETFs will depend and will vary depending on the interest-rate environment.

Third, defaults can arise here as well. So, the more-complex ETFs you venture into, the higher chances of the default risk.

Lastly, and a more important one, is the callability of the bonds. What I mean by this is the ability of the lender to redeem these bonds at a particular predefined date. If the interest rates fall, and if they have callable bonds in their portfolio, these bonds would be called back, and the money would then have to be invested in lower-yielding bonds. But the investors can take a look at the yield to worst, which is available on the websites for these bonds, that give an idea of what could be the worst yield that the investors can make if all the bonds in the portfolio are called back.

Hampton:

How do the costs compare building a bond ladder used in traditional bonds versus building one using bond ETFs?

Samant:

The defined-maturity ETFs are offered at very competitive prices right now, which is 0.1% expense ratio. So, if you were to create, say, a three-year bond ladder using three different defined-maturity ETFs, the cost would be around 0.3%.

As compared to that, if you're trying to build a bond ladder with individual bonds, it'll be a much higher cost because, firstly, the higher purchase minimums. Secondly, even if you get the higher minimum capital that you need, you would still not probably get the right price in the market because of the broker/dealer arrangements and the research costs that go into it.

Hampton:

If an investor wants to build a bond ladder ETF, how would they start?

Samant:

Firstly, the investor should define the period for which they would want to build the bond ladder, which will depend on their individual goals. So once that is decided, depending on their risk appetite on a spectrum from lower risk to higher risk, investors can go from U.S. Treasury-based ETFs to more-adventurous high-yield or emerging-markets ETFs. So, the most analogous to an individual bond ladder and the safer option would be the Treasury-based defined-maturity ETFs.

Currently, these offerings are given out by iShares iBonds and Invesco BulletShares. So, the investors can go on either of their websites, understand the structure mold, and build out a ladder there by defining different maturity ETFs. Also, these websites allow you to play with creating different bond ladders and understand the characteristics of your investments before you actually go and invest in one through your brokerage account.

Hampton:

Thanks, Saraja, for your time today and for explaining how to build bond ladder ETFs.

Samant:

Thank you.

Hampton:

High inflation is making it harder to protect purchasing power. Some investments can help hedge a portfolio against inflation. Here’s Morningstar Inc’s director of content Susan Dziubinski and Morningstar Inc’s director of personal finance Christine Benz with some tips.

It Too Late to Inflation-Proof Your Portfolio?

Susan Dziubinski:

Hi, I'm Susan Dziubinski for Morningstar. Inflation has been running hot in 2022, setting off a flurry of interest in investments that can help defend against inflation. But if you haven't yet added some inflation protection to your portfolio, is it too late to do so? And what investments might you consider? Joining me to discuss these topics is Christine Benz. She is Morningstar's director of personal finance and retirement planning.

Hi, Christine. Good to see you.

Christine Benz:

Hi, Susan. Great to see you.

Dziubinski:

Let's take a step back and talk a little bit about how worried investors should really be about inflation and their portfolios. And you think it really comes down to life stage and portfolio composition. Talk a little bit about that.

Benz:

I do, Susan. When you think about younger investors, people in their 20s, 30s, 40s, they are earning a salary. Workers have been getting pretty good inflation adjustments so far in 2022. So, that helps keep them whole on a purchasing-power basis, on an ongoing basis. If they're not withdrawing from their portfolio, they shouldn't overthink it. They should just maintain ample allocation to stocks, which over long periods of time have tended to outrun inflation, they've tended to have better returns from inflation. I want to be clear that they are by no means an inflation hedge, and I think 2022 is a perfect example. We've seen inflation up. We've seen stocks down, not doing great. If you're drawing from that portfolio, you're not in a great spot. But over long periods of time, we do see stocks outrunning inflation.

For people who are getting close to or in retirement, those are the folks who need to be a little bit more concerned about—or maybe a lot more concerned about—preserving purchasing power because to the extent that they're withdrawing from their portfolios to provide their living expenses and they have safe assets in their portfolio, so they have cash assets, they have fixed-income assets that are not explicitly inflation protected, those are all assets that are vulnerable to inflation, and that's a group that needs to be a little bit more concerned with preserving purchasing power.

Dziubinski:

Let's talk a little bit about some of the tools or investments that those folks might use to help hedge against inflation, maybe talking a little bit specifically about I Bonds and what it looks like purchasing those now after we've seen an increase in inflation already.

Benz:

Well, in this case, I really wouldn't overthink the timing question. One reason is that the built-in purchase constraints on I Bonds limit your ability to overdo it. So, you're stuck with $10,000 a year per taxpayer; a married couple can get $20,000 into I Bonds. But for most investors, that provides kind of a safeguard against gorging on I Bonds at an inopportune time. And the other nice thing is that I Bonds receive these regular inflation adjustments to help you keep pace with inflation. There's some insulation there. I think it's a really nice category for investors to maintain ongoing exposure to, to add to over the years. But remember, if you are someone with a large portfolio, you will not be able to obtain sufficient inflation protection with I Bonds alone.

Dziubinski:

And what about TIPS? That's a very common investment, either through a fund or through buying directly for retirees. What about those for inflation protection at this point?

Benz:

Right. So, TIPS are Treasury Inflation-Protected Securities. They're a relative of I Bonds. They are issued by the U.S. Treasury. They work a little bit differently in that your principal receives a little bit of an adjustment versus an income adjustment that you get with an I Bond. But they work very similarly. And the purchase limitations are much less extreme. So, you can buy a sizable allocation to TIPS. Many investors use TIPS funds. So, they outsource to a professional investor or a professional firm to bundle TIPS together.

One measure that people sometimes look at to gauge the attractiveness of TIPS at any given point in time is what's called the breakeven rate between a TIPS bond, which gives you that inflation protection, and a nominal Treasury bond. Right now, the differential is not that large, which suggests that investors who are buying TIPS bonds today have a decent margin of safety. So, if inflation goes up a lot, the TIPS bondowner, the TIPS bond buyer will be a winner, given that the breakeven rate is fairly compressed currently. I would say for most investors, don't get yourself too in the weeds in terms of thinking about the breakeven rates. I think a better idea is maybe just to dollar-cost average into the asset class over a series of months. If you decide that you want your TIPS exposure to be, say, 20% or 25% of your total fixed-income exposure, just dribble the funds in over perhaps the next year or two to get your allocation up to where you want it to be.

Dziubinski:

Christine, another common place where investors might go for some inflation protection is commodities. But we've seen quite strong performance from commodities this year. Is it too late to be sort of thinking about those for inflation protection?

Benz:

Well, I suppose the good news is that commodities' prices seem to have come down a little bit as recessionary worries have come to the fore recently. So, it's probably not the worst time to add commodities. But I think the big wild card with commodities is that it's really anyone's guess about whether they're cheap or expensive at any given point in time, because they're so dependent on what happens to the broad economy, their prices are so beholden to what happens with the broad economy that it's really hard to say whether commodities are cheap or expensive at any point in time. I have noticed by looking at fund flows into various commodities products that investors do a terrible job of trying to time their purchases, or to the extent that they're thinking about timing their purchases, we see a lot of buying high in this group. So, this is another category, because it is volatile on a stand-alone basis, if you want to maintain exposure to commodities, dribble the money in and plan to be a long-term holder of them rather than trying to get the timing exactly right.

Dziubinski:

Christine, it sounds like it's not too late to really inflation-proof your portfolio as long as you're thinking about it for over a long time period not just for the next six to eight months.

Benz:

Exactly. Think long term, practice humility, and recognize what you don't know and dollar-cost average.

Dziubinski:

Christine, thanks so much for your time today. We appreciate it.

Benz:

Thank you so much, Susan.

Dziubinski:

I'm Susan Dziubinski with Morningstar. Thanks for tuning in.

Hampton:

Thanks Susan and Christine. Subscribe to Morningstar’s YouTube channel to see new videos about market news, personal finance, and investment picks. Thanks to podcast producer Jake VanKersen who puts this show together. I’m thanking you for watching “Investing Insights.” I’m Ivanna Hampton, a senior multimedia editor at Morningstar. Take care.

Read about topics from this episode.

Disney Posts Mixed Earnings With Streaming Subscriber Growth, Record Parks Revenue But Widening Direct to Consumer Losses

Uber, Lyft Drivers Remain as Contractors

Bond Ladder ETFs Can Help Investors Climb Higher

An Update on I Bond Yield

Your Inflation Toolkit

A Down-Market Survival Guide for Your 20s, 30s, and 40s

TIPS Versus I Bonds