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Friday, April 6, 2012

Bond Index vs.Bond Ladder

Many times, when investors contemplate the difficulty of forecasting interest rates, they turn to a strategy known as a bond ladder.  With a bond ladder, you just space out the maturities so that they come due at regular intervals.  This creates a dynamic that lessens the harmful impact of falling bond prices due to yields rising and enables greater control of cash flow.  It also sets up a great way for brokers to generate commissions.  Buying individual bonds is not cheap. Typically, commissions are high and bid-ask spreads are wide, especially for the odd lots that investors trade in.  All of this in an over-the-counter market!  To get a feel for this, pick out a 5-year single A corporate or a muni for that matter and ask 2 or 3 brokers for a bid.  Brokers should be thankful that retail investors rarely look at bond laddering from a total return perspective.

Bond ladderers take comfort in the fact that the bonds will be held to maturity; and, therefore, no matter what happens to yields, they can't lose money.  This eliminates the fear that an active bond manager buys and sells at the wrong times.  It is worth noting that parking funds in a money market fund is also a way to avoid the possibility of a loss.

How does all this compare to indexing?  I'm glad you asked.  Indexing is actually highly efficient.  Bonds are replaced in the index essentially for free.  A broad index like the Barclay's Aggregate Bond Index can be tracked with a low-fee exchange traded fund like AGG, which includes all investment grade bonds with a maturity greater than 1 year.  Think about this.  When bonds hit the 1-year mark, they leave the index.  This is a time at which the yield on the bond is essentially a money market yield and, therefore, a good time to roll to a longer maturity in a steep yield curve environment.  Professional bond managers use this 'riding the yield curve' strategy on an active basis.  By doing so, they exploit the steepest part of the yield curve.

Furthermore, with the index you have a type of ladder going on.  A certain portion of the portfolio is invested in each year--just like with a ladder.  The big differences are that the index is marked to market and it is very well diversified.  It would be interesting to see a study comparing performance of a laddered portfolio with a similar duration bond index.

According to Morningstar data, the lowest return of the Barclay's Bond Index over the past 10 years has been 2.43% (2005) and the highest return has been 10.26% (2002).

1 comment:

  1. I think the laddered approach is better suited for controlling risk. The total bond index will perform poorly if we head into a period of prolonged rising interest rates. We have been in bull market for bonds since the early 1980s. Don't think rates can go anywhere but up from here.