Why Bond Laddering is a Bad IdeaMay 15th, 2012 by David Waring
By Barry Rabinowitz of BER Financial Group
Individual investors have always worried about investing in the bond market at the wrong time, since a subsequent rise in interest rates would result in a decline on the market price of their bonds. This is especially true now, as interest rates are at historic lows.
One strategy that has been widely recommended to deal with this problem is “Bond Laddering. ” This strategy involves investing in various ” rungs” of the ladder, so as not to invest all your money at the “wrong time.” A typical ladder might have 5 rungs, whereby an equal amount of money is invested in 2, 4,6, 8 and 10 year maturities. Every two years bonds mature, and you then reinvest the proceeds in ten year maturities to keep the ladder intact. The theory is that this strategy protects you from rising interest rates, since you are always having new money to invest every two years.
The problem with this with this theory is that interest rates have been declining, not rising, over the last 30 years. When I entered the investment business in 1981, interest rates were at record highs: 10-20 year US Treasuries were yielding over 14%’, and high quality municipal bonds were yielding double digit rates as well. Even with rates at record highs, investors were worried about investing at the wrong time, since there was a consensus that rates had to go higher.
The strategy to deal with this threat: Bond Laddering. Sadly, for most individuals that employed the strategy, they forfeited the opportunity to lock in record rates of interest, for periods of 10 years or longer.
What about today with rates at or near historically low levels?
The consensus of the so called experts: “Rates have to go higher.” To deal with this problem they are again recommending bond ladders as one of the strategies that can protect you from rising interest rates. Despite public pronouncements from Fed Chairman Bernanke that he will keep rates at Zero through 2014, if not longer, the experts have not changed their views about the direction of interest rates. We know that Laddering had a detrimental affect on individual’s cash flows over the past 30 years, since you would have received lower or similar yields on your successive 10 year purchases. What about today? With a very steep yield curve, investors are being paid to extend maturities and not invest short term, or utilize bond ladders.
The following example illustrates the substantial amount of tax free cash flow that is forfeited by using a Laddering Bond Strategy, rather than investing in the sweet spot of the yield curve, which is currently 15-20 years.
Lets says an individual has $500,000 to invest and employs the ” 5 rung” Bond Laddering Strategy. He invests $100,000 in 2, 4, 6, 8 and 10 year AA rated munis. According to S &P Composite, as of May 11, 2011, these rates were available for those maturities: 0.50,1.0,1.30, 1.80, and 2.40%. The rate of return would be the blended rate of the 2-10 year bonds, which equals 1.40%, or $7,000 a year of income.
With the steep yield curve, AA rates for 15 and 20 year maturities are 3.20 and 3.60, respectively. A blended rate would be 3.40%, or $17,000 a year in income, on an annual basis.
This is over twice as much as that generated by the 10 year ladder.
It should be noted that there is no free lunch in the investment world, and during periods of rising rates, the value of the longer maturity bonds might be subject to greater decline. However, even when the Fed is raising rates, the yield curve can flatten, with little affect on intermediate and longer maturities. So, it is not a sure thing that longer dated bonds will decline in price when the Fed raises rates.
Individuals buy municipal bonds for the tax free income, and not to trade them, so volatility and increased fluctuations in the market values should not be a deciding factor. As long as the bonds are held to maturity, they will be repaid at par. What if you have to sell the bonds before maturity? As with all investments you may get the same amount, more ,or less than you paid, depending upon market conditions. In general, money that may be needed should not be invested in municipals, as they should be considered a long term investment.
In conclusion, nobody can forecast rates, so the best policy is to invest for maximum cash flow, the sweet spot of the curve, and forget about “Bond Laddering.”
About Barry Rabinowitz
I worked as a bond trader for many years, and while I was in CA, in the mid 1980′s, I ran the Govt/Agency trading desk for Bank of America. I am an expert in bond investing, and for the past 15 years, living in Florida have specialized in working with retirees and helping them with investing. I am a CFP, have a MBA in finance, and have my own Registered Investment Advisory firm: BER Financial Group. We provide financial planning and investment advice for a fee. We do not sell products or work on commissions. Retirement Planning and Investing are our specialties. We help clients put together their own portfolio of individual municipal bonds.