A popular strategy for bond portfolio management is to ladder bond maturities for individual clients. This approach has been applied most often with municipal bond portfolios given the abundance of individual maturities within the market. As detailed below, there are some significant limitations and issues that this strategy represents and clients should not be lured into a false sense of security with overreaching arguments as detailed below.
Client Attitude – Individual clients like this approach and feel that it is a low risk strategy. Successful businesses are successful because those businesses give the client what they want or what they think they want. It is simple and straightforward.
Easy to Understand – This is a mechanical approach that clients find easy to understand.
Perceived as Low Risk – Clients perceive that this strategy is low risk since bond maturities are evenly distributed. Clients believe that they cannot predict interest rates and this strategy seems to isolate them from that risk. This strategy however has the same if not higher level of risk than a managed portfolio.
Win/Win Fallacy – Some sales material have led clients to believe that laddered portfolios will benefit in both rising and falling interest rate markets. This is not true! The argument presented is that if interest rates go up, then the short 1 to 3 year maturity bonds will mature and the client will be able to reinvest at higher interest rates. Likewise if rates fall, the sales material states that the high yields are locked up with the 8-10 year maturity bonds. There are no foolproof investment strategies in fixed income and the overall change in portfolio value will track the duration of the portfolio as described below.
It’s the Duration – A 10 year laddered fixed income portfolio has a duration of 4.19 years. Duration is the most common and best measure of risk that is used for fixed income portfolios (it is comparable to the Beta in equity investing). Duration is an estimate of the portfolio change in value given a change in interest rates. To illustrate, if interest rates increase by 1% (all other factors being equal), the overall portfolio will have a price change equal to -4.19% which is the duration. Likewise, if interest rates go lower by 1%, the price change will be positive by an estimated +4.19%. There is no win/win outcome when the return on the entire portfolio is measured.
No Advice Channel – Investment Firms that use bond ladders are usually low advice channels and use a buy and hold approach to bond management.
Best Relative Value - Since laddering is a mechanical process, there is little attention to best relative value of different bond offerings. Users of bond laddering are focused on fulfilling their maturity mandate and as a result bonds that do not fit the maturity need yet represent attractive value are generally ignored.
Interest Rate Outlook – Today we are historically low interest rates and there is a strong argument that inflation will increase in the near term and force interest rates upward. Laddering will still produce a 4.19 year duration, is mechanical and does not allow the Portfolio Manager to capitalize on their interest rate view. Don’t you deserve a strategy that will capitalize on the future direction of interest rates?
Our Strategy – We set up intermediate bond portfolios with maturities between 1-12 years. We adhere to a discipline of dividing our maturities in 3 segments – 1-3 years, 4-7 years and 8-12 years. Then we pick best relative value within these sectors with the discipline of maturity diversification in the 3 maturity segments. Laddering restricts the judgment and value that a Fixed Income Portfolio Manager can provide to the client’s portfolio.