By Anthony Davidow
Bond laddering, one of the tried and true approaches to managing fixed income portfolios, has been around for a long time and can be suitable for many goals. The concept itself is quite simple: purchase a portfolio of fixed income securities with staggered maturities, extending out the yield curve. Each year, as bonds mature--i.e., one rung of the "ladder" reaches maturity--the proceeds can be diverted to meet income needs, or be reinvested into bonds with a later maturity.
A key benefit of this approach is maintaining exposure to fixed income assets while managing interest rate risk. In addition, laddered portfolios are useful in managing cash flow needs, and building portfolios targeted to future life events, like funding college tuition, taxes or retiring on a specific date.
Customized Ladders For Customized Needs
Beyond this very general concept, however, laddered portfolios run the gamut from simple to complex and can get complex very quickly--taking a lot of an investment professional's time to develop and implement. It can become very time consuming for an advisor to research and source bonds in the market. ETFs can be a simple, cost effective alternative to meet both types of needs.
At the simpler end of the spectrum, one might have a young investor accumulating assets who doesn't have immediate liquidity needs. Portfolios for these kinds of "accumulators" likely require some exposure to bonds as a volatility dampener and a way to get diversification relative to equities. A plain-vanilla ladder that rolls over every year would likely meet their needs in an interest-rate agnostic way.
At the other end of the spectrum, a baby boomer who is approaching, or already in, retirement has a much different mindset. The goal here is de-accumulation. And while we believe the financial industry has done a great job for the last 30 years helping investors with asset accumulation goals, financial advisors need more tools to manage clients' de-accumulation in an orderly fashion. That's where maturity targeted ETFs can be a valuable option.
With target maturity ETFs, advisors can build extraordinarily complex ladders for a very low cost-weighting each rung of the ladder according to each client's specific cash flow needs over a ten-year period.
For example, consider a client who is retiring in five years. That client is no longer going to be merely taking home the interest income, they are likely to also be taking a portion of principal out each year. The ladder can easily be weighted toward the latter part of the timeline to increase both the interest income maturing principle at retirement. And even within the latter five years, the ladder can be further weighted to whatever maturity schedule best meets the client's market outlook and income needs. Bond mutual funds have a "perpetual maturity."
In other words, if a bond fund has a maturity of three years today, three years from now it will likely have a three-year maturity as well.
Thus, target maturity ETFs ladders can provide both income and principle in a very orderly fashion as they have both "permanence" and "definition" like an individual bond-i.e., a specific maturity date, and a projected return based on the fund's income. Bond mutual funds leave the investor at the mercy of the fund's NAV at the date the funds are needed.
With ETFs, investors may benefit from monthly income, and advisors can actually schedule fund maturities to coincide with the client's needs-potentially at a fraction of the cost of managing portfolios of individual bonds. Analysis by the indexer Accretive Asset Management suggests that "round-trip" transaction costs (i.e., buying and then selling the asset) can be as much as 16 times higher for individual bonds compared to fixed-income ETFs. (1)
Reducing Complexity: Managing Income, Risk and Liquidity
Bond ladders can become even more complex when one takes into account both income needs and risk tolerances. With Treasury yields at historic lows, investors with a need for current income often have to diversify into higher yielding instruments. Some allocation to corporate investment-grade and high-yield corporate securities within the bond ladder may be necessary to hit the yield targets the client needs. And the choice of vehicle can affect the income stream: individual corporate bonds often pay interest semi-annually, which can be "lumpy" for clients who want to tightly manage their cash flow and need a steadier revenue stream.
In addition, gaining that investment grade and high yield exposure with individual securities can be research-intensive, requiring credit analysis. With target maturity ETFs, however, advisors can easily create ladders that offer diversified access to the entire bond market. ETFs are transparent, diversified portfolios often comprising 50-100 securities, and as such offer an attractive alternative to building portfolios one bond at a time-particularly with respect to liquidity.
ETFs are exchanged-traded, compared to the vast majority of corporate bonds (whether investment grade or high yield), which are traded in the over-the-counter market. The quality of execution with individual bonds may be inferior compared to trading target-maturity fixed income ETFs. For bonds held to maturity, there may be less impact on the investor. But if plans change and investors need to raise cash before their bonds mature, they may incur much greater cost with an individual bond compared to an ETF.
The Potential Benefits And Complexities Of Laddering
Every client is unique in investment objective, income needs, time horizon and risk tolerances. And before the development of target maturity ETFs, building customized laddered bond portfolios could be a cumbersome and expensive process. Now, however, meeting individual client needs can be much simpler. Ladders can be weighted across a ten-year horizon according to the income and risk preferences of the client-all at a fraction of the cost of individual bonds, and with a more predictable return stream than bond mutual funds.