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Ladder Up!
Laddering a Bond Portfolio Will Substantially Reduce Your Client’s Exposure to Interest Rate Volatility
by George Strickland
From Financial Planning Magazine, June 2001. Reprinted with permission.
any advisers purchase bonds and bond funds as a part of their clients' comprehensive investment portfolios. They are attracted because of their perceived safety and high yields. Of course,not all bonds and bond funds are the same. Investors are consistently lured by high yields into high-risk bond strategies, only to lose principal. Remember the stock market crash in 1987? More money was lost in bonds that year than in stocks.
As interest rates fluctuate, the present value of a bond's stream of interest payments constantly changes — and the longer stream of interest payments, the higher the price volatility. The market value of a bond goes down when interest rates rise because its interest rate is fixed and cannot compete with newly issued bonds paying higher rates.
In terms of variability of total return, long-term bonds look more like stocks than short-term, fixed-income vehicles. Eugene Fama studied the rates of returns of long-term bonds from 1964 to 1996, showing that these bonds historically have had wide variances in their rates of total return, without sufficiently compensating investors with higher expected returns. The historical statistics to support the theory are shown in Figure 1.
Figure 1. Risk Without Reward
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Annualized risk and return 1964-1996
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Mean Return
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Standard Deviation
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Treasury Bills
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5.98%
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2.68%
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Intermediate-term Treasury notes
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7.35%
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6.65%
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Long-term Treasury notes
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7.01%
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11.40%
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Source: Ibbotson & Associates
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The data indicate long-term U.S. Treasuries have both lower average returns and higher price volatility than intermediate-term Treasuries. Investors have not been compensated for the higher risk of long-term bonds. How can the adviser use these fixed-income vehicles to their clients' advantage? A classic bond investment technique called laddering can provide the solution. Let me explain.
Laddering a portfolio requires buying and holding equal amounts of fixed-income securities designed to mature over a defined period that can range from one to 20 years. When the shortest security matures, it is replaced with a purchase of an equal amount of the longest maturity in the ladder. (See Figure 2.) Laddering tends to outperform other bond strategies because it simultaneously accomplishes two goals: 1) captures price appreciation
as the bonds age and their remaining life shortens, and 2) reinvests principal from maturing short-term bonds (low-yielding bonds) into new longer-term bonds (high-yielding bonds).
Figure 2. 1-20 Year Ladder
So, how do you build a ladder? I believe it is best to allocate 6% to 10% of a portfolio in each year of the ladder. We build two basic ladders: The average maturity of a short-term ladder is kept between four and five years. An intermediate-ladder will have an average maturity of somewhere between seven and 10 years. The longest bonds we would own would be 20-year bonds.
As short-and intermediate-term bonds age, their durations shorten at an increasing rate, in a telescoping effect. A single year of aging will benefit a five-year bond more than it does a 10-year bond; and will benefit a 10-year bond more than a 20-year bond. A 30-year bond hardly benefits at all from a single year passing.
In Figure 3, compare three identical bonds with 6% coupons, except one has 30 years to maturity, one has 20 years and one has 10 years. Note what happens to duration after five years of aging.
Figure 3. Measuring Duration
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30-year bond
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20-year bond
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10-year bond
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Initial Duration
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13.8
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11.6
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7.4
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Duration after 5 Years
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12.9
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9.8
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4.3
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Change in Duration
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0.9
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1.8
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3.1
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% Change in Duration
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6.0
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15.0
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42.0
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Why is it helpful to have a shortening duration? A bond with a shorter duration carries less risk, which means a potential buyer will demand less yield. If interest rates are constant and the yield curve is positive sloped, the bond will rise in value over most of its life as its duration shortens. If interest rates rise, the bond will recover much, if not all, of its lost value as its duration shortens.
Important Tip: A bond's sensitivity to interest rates is measured by its duration. The shorter the duration,the less volatile the bond's price. When interest rates shift,a bond with a one-year maturity barely budges in price, while the price of a 30-year bond gets whiplash. This means long-term bond funds pay a heavy price for their marginally higher yields.
In Figure 4, we build a portfolio by buying one bond each year out to 10 years. We then assume three different interest rate scenarios. The centerline represents unchanging interest rates. Here, you get a very steady return each year in your laddered portfolio. That return will be fairly close to the highest-yielding bond in the portfolio.
Figure 4. Hypothetical Portfolio
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Initial Yield Curve Years to Maturity
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1
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2
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3
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4
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5
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6
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7
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8
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9
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10
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Initial Yield Curve Years to Maturity
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3.92
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4.16
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4.34
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4.47
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4.56
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4.65
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4.73
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4.80
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4.86
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4.83
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What happens when interest rates rise? Your bond values drop, but only temporarily. And, unlike owning an individual bond, the ladder has maturing bonds each year, which gives the portfolio a stream of cash to reinvest in new, cheaper, high-yielding bonds. That creates a consistent pattern of investment, much as dollar-cost averaging does for the equity market.
Without maturing bonds, the fund manager would be forced to sell bonds at depressed prices as a way of generating cash for reinvestment. As proceeds from maturing bonds are reinvested in higher-yielding bonds at the far end of the ladder, the portfolio's yield gradually increases.
This built-in feature works to offset some of the price depreciation that exists throughout the ladder. As you can see, after a few years the portfolio's return first equals its original return — then surpasses it.
What if interest rates fall? Initially the portfolio's return gets a lift as bond prices get marked up. Ultimately, as those bonds mature and proceeds are reinvested in lower-yielding bonds, the portfolio's long-term return is lower than it would have been under the other two scenarios.
We base our buying decisions on the five-and 10-year points of the yield curve. Let's look at a chart that represents an average yield curve over the last five years in the municipal bond market.
In Figure 5, the horizontal axis represents years to maturity. The vertical axis represents the yield you can expect to earn on that bond. A normal yield curve means that very short-term investments generate the lowest yields. As you increase the years to maturity of your investment, your yield levels rise. In the municipal market,for the first five or six years of that yield curve, yields go up substantially for each year. You hit what we call an "elbow" in the yield curve at about five years.
Figure 5. Municipal Yield Curve
As you can see, the first five to 10 years of that yield curve is the steepest part. Steep is good in bond investing because that means you only have to go a little further out for your yield on the bond to increase a lot. Once you get past 10 years,and even more noticeably after 15 years,the yield curve is virtually flat. Thus, a 30-year bond with more inherent risk gets virtually the same yield as a 15-year bond. The longer you wait, the more risk you take.
Who’s Calling?
Most bonds have what is called a "call provision," which means that the issuer of that bond can repay the bond early. Advisers frequently don’t understand this issue of callability and how it can affect their clients’ portfolios, but they would do well to learn. Let’s say you own a New York City bond that has a call provision, and New York City decides it wants to pay off that bond. The city can issue new bonds at a lower interest rate. Obviously, if they were going to issue new bonds at 5%, you would want to keep those old bonds that are paying 7%. But, if the city has a call provision, you can’t keep the higher rate bonds. More than 90% of the municipal bonds that are issued have a 10-year call provision. Even if you buy a 20- or 30-year bond and interest rates drop so your bond pays an above-market yield, after 10 years, that bond will probably be called away from you. Then your clients took all that risk for nothing! Even worse, if interest rates rise and your yield is below market, there is no way the issuer is going to call the bonds. It is preferable to buy only non-callable bonds, or bonds only callable within a few years of maturity, as opposed to having 10, 15 or 20 years between your call date and the maturity of the bond.
Laddering reduces interest rate risk because it shortens the average maturity of a portfolio and reacts to changing interest rate conditions. If you can focus on the fact that it really doesn't matter which way interest rates go and that you're going to get about the same return, you'll realize that it's always a good time to buy into a laddered portfolio.
George Strickland is managing director of Thornburg Investment Management in Santa Fe, N.M.
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