Building bond ladders eases investor angst

Investors are frustrated these days as they seek to sustain portfolio values after the onset of the new bear stock market. Many are chagrined to learn that bonds, once a paragon of stability, are no longer an automatic solution for wealth preservation.

Although bond yields have been increasing on average lately, they are still quite low historically. Atop this, historically high inflation continues to pose a severe risk.

The current bond market also carries a high level of interest rate risk — the chance that the value of your bonds on the secondary market may be pummeled by rising interest rates. After all, why should anyone buy your bond at the yield you locked in at time of purchase when they can get higher yield from a newly issued one?

A market environment where stocks and bonds are both down is perplexing for investors who have long believed that bonds can be relied upon to provide income with low risk — a refuge when stock values are low. Yet, like stocks, bonds are now a source of angst for many investors.

However, there is an effective way of easing this angst. It is called a bond ladder, a strategy that involves buying bonds of varying, sequential maturities. This enables investors to rotate into higher-yielding bonds as rates rise, adding rungs to the ladder. To manage inflation risk, the average maturity of bonds in ladders should not be too long.

An example of a bond ladder would be bonds purchased in three maturity categories: short term (one to two years), medium term (two to five years) and longer term (five to seven years). When the shorter-term bonds reach maturity, the investor might want to buy more bonds at the top rung of the ladder (those with longer maturities). As a result, the top rung of the ladder may keep getting higher, or further into the future. For example, as they mature, bonds of shorter maturities can be rolled into holdings at the seven-year-maturity rung. The time horizon of the longest bond should be set according to the individual client’s risk tolerance and goals.

This strategy is only appropriate for investors with substantial portfolios. Many bonds require a minimum investment of at least $10,000, so it’s difficult for people with a bond portfolio of much less than $200,000 (and a much larger total investment portfolio) to achieve sufficient diversification — preferably achieved by maintaining a maximum per-issuer allocation of 5% of the total bond portfolio. Diversification of bond issuers is critical to managing risk.

For investors with smaller portfolios, a better alternative is to construct a ladder of bond exchange-traded funds or mutual funds, or to buy shares in one or more diversified funds owning bonds of different maturities. This affords more accessible exposure to laddering than owning individual bonds. Investors should be mindful of the risks stemming from having no underlying contractual maturity date. Holders of actual bonds have these dates.

For investors with total investment portfolios of $1 million or more, owning a ladder of individual bonds is a good way to invest in bonds in the current market. Such investors typically have advisers and investment managers, and when it comes to bond ladders, this is a good thing because this strategy requires extensive credit and market expertise.

Yet for investors with advisers, it is nonetheless important to understand how this strategy works so they can work with their advisers effectively. That way, they will have a realistic idea of what to expect and can adjust their long-term retirement or spending goals accordingly.

The main goal of a bond ladder is to hold bonds until maturity and reinvest the proceeds of retired bonds into those paying higher yields — the risk-adjusted yields available at the time. This way, inflation will not reduce as much of the buying power of your invested capital over time. Thus, over time, you will have opportunities to reinvest proceeds of lower-yielding bonds at higher rates.

Holding bonds until maturity reduces interest rate risk, as this enables investors to avoid selling on the secondary market, which may be pricing your bonds at a loss at the time you might decide to sell them.

Constructing and managing a productive, risk-managing bond ladder is more complex than it appears and requires extensive knowledge of the dynamics and nuances of the bond market.

Here are a few points to keep in mind:

The first rule of a bond ladder is to have discipline — to avoid selling a bond at a loss. Usually, the simplest way to avert this is to plan long in advance to hold bonds until maturity.

Many investors focus on yield alone, but this is a simplistic approach that can be extremely faulty. Known as chasing yield, this practice fails to assess various risks, credit risk being the most important. When even one bond becomes impaired or defaults, it is hard to recover. Chasing yield can also result in owning too many long bonds — those with maturities of 20 to 30 years. Investors who chase yield often overlook the importance of managing a bond ladder’s duration, or price sensitivity. The longer the duration, the greater the potential for volatility and the greater the risk. An adviser can help a client build a bond portfolio instead of just a collection of bonds.

Effective ladders can be built from various types of bonds, depending on an investor’s tax situation and risk tolerance. Most portfolios of individual bonds are composed of Treasurys, corporate or municipal bonds. Each type has its own tax implications, credit risk, yield ranges and other characteristics. Each type also trades differently. Credit risk is the lowest with Treasurys, but investment-grade corporates (those with credit ratings of BBB and above) are also a common option. Bonds below this rating threshold are junk bonds, euphemistically called “high-yield” bonds. These are usually a suboptimal choice for most individual investors, and now that many economic forecasts put recession right around the corner, they’re even less desirable because of an increased risk of default. Municipal bonds issued for general and essential services that are rated A or better are recommended for those in high tax brackets.

By working with an adviser and possibly a bond manager, you can structure a bond ladder that makes sense for your overall asset allocation, long-term goals and risk tolerance. Creating an individual bond portfolio can help you position for income and wealth preservation. During this difficult market period, these benefits can ease angst considerably.

David Robinson, CFP, is a director and senior wealth adviser with Mariner Wealth Advisors in the firm’s Phoenix office. He provides wealth planning services and creates custom financial plans to help clients grow and protect wealth, manage taxes and identify insurance solutions. He also prepares clients for retirement and manages estate plans. Prior to joining Mariner Wealth Advisors, he was CEO of Robinson, Tigue and Sponcil, an SEC-registered advisory firm in Phoenix.