The Pros and Cons of Bond Laddering

Q: I hear a lot of investors talking about bond laddering these days. What does that mean and how does it work?

A: "Laddering" refers to holding cash equivalent or income-yielding assets of different maturities in a portfolio, with the goal of creating predictable streams of cash flow. You can build a ladder using certificates of deposit, bonds--anything that has a fixed payment amount. You then hold these securities until they mature--picking up any income produced along the way--and get back your principal amount back at maturity.

Pros of Bond Laddering Let's say that you know you will need about $20,000 every few years for the next 10 years to cover your expenses. You decide to buy individual bonds that mature when the money is needed and then spend that money instead of reinvesting it.

Let's construct a $100,000 bond ladder using Treasury securities, at current rates.

The current interest-rate environment doesn't much matter to you if you'll get your bond's face value back at maturity. You also don't need to worry about incurring capital losses by selling your bonds for a discount in a rising-rate environment because you're holding the bond to maturity. So you've "immunized" your portfolio from two risks--interest-rate risk and reinvestment risk.

Bond mutual funds, on the other hand, can lose money when interest rates rise. Pretend you're a bond fund portfolio manager. You need to sell a bond to meet investor redemptions; you sell a 10-year bond, $1,000 par value, with a 5% coupon. But new 10-year bonds are being issued with 8% coupons. Why would someone want to buy our bond, which pays $50 per year, when he or she could buy one for the same price that pays $80 per year? To entice someone to buy our bond with its lower yield, we'll have to mark the price down to less than $1,000, thus raising the buyer's yield closer to 8%.

So bond laddering has some advantages, but there are other considerations. For one, the success of the bond ladder strategy is contingent on the bonds supplying your cash flows not defaulting--and this is no minor risk. This is why you should build a bond ladder with stable, high-quality, noncallable bonds. (Callable bonds can be paid by the bond issuer before maturity.)

Cons of Bond Laddering While bond laddering may allow you to circumvent interest-rate risk and reinvestment risk by holding individual bonds until maturity, the strategy can court risk on other fronts. Most of these risks are the same ones we mention when discussing holding individual bonds versus bond mutual funds: default risk, research complexity, diversification risk, and high trading costs.

To find the best opportunities, professional bond fund managers go beyond bond ratings issued by credit ratings agencies. They have the expertise and requisite resources to evaluate bond issuers' creditworthiness as well as other features of the bond. How healthy is the company, and, in turn, how likely is it to make good on its debts? And if a company's financial health is questionable, how much extra yield should you receive as compensation for taking the extra risk of buying its bonds? (Morningstar can help individual-bond buyers on the research front: Check out our Morningstar Credit Ratings site.)

Another hurdle individual-bond buyers face is the difficulty of building a well-diversified portfolio without a ton of money. Bonds are typically issued with face values of $1,000, but you may need to buy a block of several bonds from a single issuer to obtain decent pricing. And if the bond defaults, a big chunk of your bond allocation is wiped out if your portfolio isn't well diversified.

In a related vein, individual-bond buyers, particularly those without a lot of money to invest, can face high trading costs when transacting in individual bonds. Even investors who are buying many thousands of dollars' worth of bonds may face much higher bid-ask spreads than institutional buyers who are trading millions might pay. Those high bid-ask spreads occur when a bond buyer purchases a bond that's already trading on the market; as compensation for facilitating the trade, the broker/dealer will mark up the bond's price above where it's currently trading and will purchase it back at a price below its current value. These bid-ask spreads will tend to be higher for smaller investors than for larger ones and can, therefore, eat into the smaller bond investor's take-home yield and total returns.

In contrast, bond-fund managers can assemble a very broadly diversified portfolio of bonds for a low cost--corporate bonds, government bonds, asset-backed bonds like mortgage-backeds, as well as munis--thereby reducing the damage that any one holding can inflict on their overall portfolio.

Lastly, perhaps the biggest drawback of bond ladders in my opinion, is that you deprive yourself of the possibility of capital gains. This is the flip side of the "pro" above concerning capital losses. It can be tough to look beyond the current environment where interest-rate increases are a near certain, but what will rates do over the next 20 years? It's hard to predict. When interest rates decline, bonds appreciate in value. Mutual fund managers can sell bonds for a gain, but in a bond ladder you are locked in.

This Vanguard paper concludes that while constructing an individual bond portfolio gives an investor control over security selection, it often exposes him or her to higher costs and additional risks. Unless an investor has the resources to achieve "scale comparable to that of a mutual fund," he or she should opt instead for a low-cost, diversified bond portfolio, Vanguard says.

What's the Best Way to Go? To reiterate, if you want to create a bond ladder, it's best to home in on stable, high-quality, noncallable bonds instead of those with the highest yields. Of course, default risk won't be an issue if you stick with Treasuries, because they are backed by the full faith and credit of the U.S. government. But Treasuries don't yield as much as other bonds that take on more credit risk; a worry is that Treasury yields may not even keep pace with inflation.

Another option for investors wanting to ladder and looking for diversification are defined-maturity bond mutual funds and exchange-traded funds. These combine some characteristics of individual bonds--a single, known maturity date and a distribution of net asset value upon maturity--with the diversification of bond mutual fund portfolios. Some potential drawbacks of DMFs include costs in the form of expense ratios and transaction costs. Also, as with bond mutual funds, DMFs don't guarantee that an investor won't experience capital losses: The payout received at maturity may be less than the amount initially invested.