The Laddered Bond Portfolio
A Bond Strategy for Balancing Risk and Return
by Christopher Ryon, CFA, Jason Brady, CFA,
Josh Gonze, and Lon Erickson, CFA
Thornburg Fixed Income Co-Portfolio Managers
The bond-market turmoil that began in late 2008 served as a stark reminder to fixed- income investors that various forms of risk, if denied, unacknowledged, or left poorly managed, can wreak havoc on portfolio values. Contrast what happened to bond investors (many of whose portfolios contained far more credit-related risk than they or even their advisors were aware of) to the experience of equity market investors since 2008, and it becomes clear that the risks of fixed-income investing are very real, and that bond portfolio values can fluctuate dramatically.
The stock market crash of 1987 provides a more distant illustration of the risks of fixed-income investing. The crash was highly dramatized in the media, but more money was lost in long-term bonds and bond funds that year than in stocks. Rates fluctuated wildly and rose dramatically by year end, causing bond portfolios to lose significant value. Why? When interest rates rise, market values of bonds go down, because bond interest rates are fixed and the present value of a bond’s stream of interest payments drops. These factors caused investors to panic and sell their bond funds, leaving fund managers with no choice but to sell long-term bonds at a loss to generate cash for redemptions.
At Thornburg, we believe that the slightly higher nominal yield of long-term bonds must be carefully considered in relation to their volatility.
Higher Historical Volatility of Long-Term Bonds
Long-term bond investors enjoyed their best decade in history between the late 1980s and early 1990s, with gains averaging 12.7% per year. The worst decade for long-term bond investors was the 1950s. During that time, annual losses averaged -0.1% (with reinvested income; substantially lower otherwise). The recent interval that followed the credit crisis has awakened investors to longterm bonds’ volatility, and more investors are aware of the risks — many of them acutely.
Over the past 50 years, as figure 1 illustrates, longer-term bonds have returned slightly more (7.23% versus 7.05%) than intermediate-term bonds, but their volatility of returns, as measured by standard deviation, has been markedly higher. Figure 2 depicts the greater-than-12% price change of a 30-year U.S. Treasury over the span of less than one month in late 2011. Even when compared to short-term U.S. Treasury bills, the increased total return of long-term bonds (in this case, 20-year U.S. Treasuries) versus their heightened price volatility is, at minimum, a tradeoff that must be carefully considered.
The short-and intermediate-term laddered portfolios managed by Thornburg seek to mitigate the various forms of risk and smooth the price volatility typical of longer-term bonds.
There are four main risks inherent in every bond and bond fund: credit risk, income tax risk, market price risk, and reinvestment risk. It is possible to mitigate credit risk by researching and monitoring a bond, and income tax risk can be minimized by investing in tax-free bonds or using a tax-deferred account, but it is impossible to simultaneously master market price risk and reinvestment risk.
So, while it’s true that some investments do alleviate some of the above factors, no single investment can fully manage all of them. Market price risk (see figure 2), for example, can best be curtailed by owning a limited-term certificate of deposit (CD) or a money market fund, because the market price is always constant. But reinvestment risk is, as a result, comparatively larger when investing in a CD or money market fund (see figure 3). Reinvestment risk can be diminished through investing in zero-coupon bonds (bonds that are not contracted to make periodic couponpayments) because reinvestment is fixed until maturity, but a zero-coupon bond is subject to market risk. All other bonds are subject to both market and reinvestment risk.
At best, an investor in a fixed-income vehicle other than the above instruments can hope only for a compromise solution that minimizes and manages market price and reinvestment risk, while achieving an attractive total return (see figure 4).
Striking a Balance: Laddering the Portfolio
How do fixed-income investors achieve a respectable rate of return without experiencing the higher risk associated with the fluctuation of interest rates?Further, what is an adequate trade-off of higher risk for higher return?
Laddering involves building a portfolio of bonds with staggered maturities so that a portion of the portfolio will mature each year (see figure 5). To maintain the ladder, money that comes in from currently maturing bonds is typically invested in bonds with longer maturities within the range of the bond ladder.
Laddering tends to perform very well against other bond strategies over the long term because it simultaneously accomplishes two goals:
- Captures price appreciation as the bonds age and their remaining life shortens.
- Reinvests principal from maturing bonds (low-yielding bonds) into new longer- term bonds (higher-yielding bonds).
Managing Market Price Risk
The primary goal of a laddered bond portfolio is to achieve a total return over all interest rate cycles that compares favorably to the total return of a long-term bond, but with less market price and reinvestment risk. This goal is pursued by maintaining an investment of approximately equal amounts of a bond portfolio in each year of the selected maturity range.
A bond’s sensitivity to interest rates is measured by its duration. The shorter the duration, the less volatile the bond’s price. When interest rates shift, a bond with a one-year maturity barely budges in price, while the price of a 30-year bond moves dramatically (as shown in figure 6). Long-term bond funds pay a heavy price for their marginally higher yields. As limited- and intermediate-term bonds age, their durations shorten at an increasing rate, in a telescoping effect. A single year of aging will shorten the duration of a five-year bond more than it does a 10-year bond and will benefit a 10-year bond more than a 20-year bond. A 30-year bond’s duration, on the other hand, hardly responds to a single year’s passing.
Figure 7 compares three identical bonds with five percent coupons. The first bond has 30 years to maturity, the second 20 years, and the third 10 years. Observe the effect on duration after five years of aging.
The shorter-duration bond carries less risk, so a potential buyer will demand less yield. If interest rates remain constant, the bond will rise in value over most of its life, as its duration shortens. If interest rates rise, the bond will recover much (if not all) of its lost value as duration shortens, and is priced to the lower yield of a shortened bond.
Figure 8 shows the price of an intermediate bond from issuance until maturity (assuming that bond yields are held constant during the investment period). Note how the price rises over most of its life. This scenario, when applied to a laddered-maturity portfolio, reduces market price risk because there are generally more bonds rising in price than falling in price.
Managing Reinvestment Risk
In a laddered portfolio, bonds mature every year. As this occurs, the principal proceeds are reinvested at the longer end of the ladder, often at higher interest rates. The income stream will stay relatively constant because only a small portion of the portfolio will mature and be replaced each year. Over time, the portfolio should include bonds purchased in periods of both high and low interest rates. Figure 9 demonstrates how a laddered portfolio can be expected to react to three interest rate scenarios:
UNCHANGED INTEREST RATES (The center line in the graph in figure 9 represents a scenario of unchanging interest rates.)
In this scenario, a very steady return is generated each year in the laddered portfolio. The return will be fairly close to the highest-yielding bond in the portfolio.
RISING INTEREST RATES (The gold line in the graph in figure 9 represents a scenario of rising interest rates.)
Bond values initially drop, but recover value as they move toward their maturity at par. Unlike owning an individual bond, the ladder has maturing bonds each year, which gives the portfolio a stream of cash flow to reinvest in new, higher-yielding bonds. This creates a consistent pattern of investment, much as dollar cost averaging does for the equity market. Without maturing bonds, the manager could only sell bonds at depressed prices in order to generate cash for reinvestment. As proceeds from maturing bonds are reinvested in higher-yielding bonds at the far end of the ladder, the portfolio’s yield gradually increases. This built-in reinvestment feature works to offset some of the price depreciation that occurred throughout the ladder when interest rates rose. It also results in a rising income stream. As can be seen, after a few years, the portfolio’s total return first equals its original return — then surpasses it.
WHAT IF INTEREST RATES FALL? (The dark blue line in the graph in figure 9 represents a scenario of falling interest rates.)
In this scenario, the portfolio’s return rises as bond prices are marked up. Ultimately, as those bonds mature and proceeds are reinvested in lower-yielding bonds, the portfolio’s longterm return is lower than it would have been under the first two scenarios. The income stream also decreases, but only gradually, because the longer-term higher-yielding bonds continue to be held in the portfolio and the income generated continues to be the average of all the bonds.
Why Does this Tactic Work?
Let’s look at an average bond yield curve (shown in figure 10) for three years from 2011– 2014. The horizontal axis represents years to maturity and the vertical axis the expected yield. A normal (positively sloped) yield curve means that the shortest investments generate the lowest yields. As years to maturity increase, yield levels rise. Yields rose substantially every year for the first 10 years of the curve.
As figure 10 shows, the first five to 10 years of the curve is the steepest segment; a steep curve is good for bond investors, because yields will increase rapidly over a short time frame. Beyond 15 years, the yield curve flattens a bit, and little increase in yield results even as maturities extend and more risk is assumed.
As maturing proceeds are reinvested at the end of the ladder, the yield of the portfolio is greater than what would be expected by the average maturity of the bonds, because of the positive slope of the yield curve. As a result, over time, a laddered portfolio of bonds tends to produce a portfolio with the income of the longer-maturity bonds but with the price stability of the middle-maturity bonds in the ladder.
Strategies which help manage both price volatility and reinvestment rates are: laddering the portfolio, focusing on short-term and intermediate- term bonds, reinvesting proceeds at the end of the ladder rather than the front, and allowing bonds to naturally age down the yield curve. We believe that the practice of laddering a portfolio throughout all market environments provides the most attractive means of managing both market price and reinvestment risk.
Other Things You Should Know
Most bonds have a call provision, which means that the issuer of that bond can repay the bond early. Financial advisors frequently don’t understand the issue of callability and how it can affect their clients’ portfolios. A goal of a properly structured laddered bond portfolio should be to buy only non-callable bonds, or bonds that are only callable within a few years of maturity (as opposed to having 10, 15, or 20 years between the call date and the maturity of the bond).
For example, consider a New York City bond with a call provision and assume that interest rates have gone down. In this case, the city will call the bond and issue new bonds at a lower interest rate. Obviously, if the new bonds were issued with a four percent yield, the investor would prefer to retain the old bonds that are paying six percent, but if the city has a call provision, the investor must surrender the higher-rate bonds.
More than 90 percent of longterm municipal bonds issued have a 10-year call provision. Therefore, a 20- or 30-year bond paying an above-market yield will probably be called within 10 years. As such, the investor would not be compensated for assuming the greater risk, since the high-yielding bond gets called before its final maturity. Worse, if interest rates rise and the bond’s yield is below market, the issuer is not likely to call the bonds and the investor would own the below-market bond all the way to its final maturity. With a laddering strategy, which uses only limited- or intermediate-range bonds, call risk tends to be lower.
Laddering short-term and intermediate-term bonds captures most of the return of longer-term bonds, with less volatility. For example, a 10-year ladder can produce the yield and return of 10-year bonds, but with lower risk because of its five-year average maturity. The strategy also smooths out reinvestment risk since money is being reinvested incrementally throughout a full interest rate cycle. The end result is a portfolio with returns close to those of long-term bonds but with substantially less risk.
It really doesn’t matter which way interest rates move. With a laddering strategy, it’s possible to get consistent returns. This gives laddering investors a competitive advantage, knowing any time is a good time to build or buy into a laddered portfolio. It’s the smart way to increase a portfolio’s return while minimizing both market and reinvestment risk.
Fixed Income Portfolio Managers
JASON BRADY, CFA, is a managing director for Thornburg Investment Management. He is the portfolio manager of the Thornburg Limited Term U.S. Government Fund, Thornburg Limited Term Income Fund, Thornburg Investment Income Builder Fund, Thornburg Strategic Income Fund, and Thornburg Low Duration Income Fund. Prior to joining Thornburg, he was a portfolio manager with Fortis Investments in Boston and has held various positions at Fidelity Investments and Lehman Brothers. He holds a BA with Honors in Environmental Biology and English from Dartmouth College and an MBA with concentrations in Analytical Finance and Accounting from Northwestern’s Kellogg Graduate School of Management.
LON ERICKSON, CFA, is a managing director for Thornburg Investment Management and portfolio manager of the Thornburg Limited Term Income Fund and Thornburg Low Duration Income Fund. Prior to joining Thornburg, Lon spent almost 11 years as an analyst for State Farm Insurance in both the Equity and Corporate Bond Departments. Lon earned his BA in Business Administration with a minor in Economics from Illinois Wesleyan University and his MBA from the University of Chicago Graduate School of Business.
JOSH GONZE is a managing director for Thornburg Investment Management and portfolio manager of the Thornburg Municipal Bond Funds. Prior to joining Thornburg, Josh served as an associate director at Standard and Poor’s, where he set credit ratings for corporate bonds. Prior to Standard and Poor’s, Josh worked in corporate banking at the Toronto-Dominion Bank in New York. Josh holds a BA in Economics from Oberlin College and an MBA in finance from the New York University School of Business.
CHRISTOPHER RYON, CFA, is a managing director for Thornburg Investment Management and portfolio manager of the Thornburg Municipal Bond Funds. He has almost 30 years of investment management experience. Before joining Thornburg, Chris served as head of the Long Municipal Bond Group for Vanguard Funds. There, he oversaw the management of over $45 billion in 12 intermediate- and long-term municipal bond funds. Chris holds a BS from Villanova University and an MBA from Drexel University.
Past performance does not guarantee future results.
Bonds and bond funds are subject to certain risks including interest-rate risk, credit risk, and inflation risk. The value of a bond will fluctuate relative to changes in interest rates; as interest rates rise, the overall price of bonds fall. Unlike individual bonds, bond funds have ongoing fees and expenses.
The laddering strategy does not assure or guarantee better performance than a non-laddered portfolio and cannot eliminate the risk of investment losses.
The views expressed are those of Thornburg Investment Management. These views are subject to change at anytime in response to changing circumstances in the markets, and are not intended to predict or guarantee the future performance of any individual security or the markets generally, nor are they intended to predict the future performance of any Thornburg Investment Management account, strategy or fund.
A bond credit rating assesses the financial ability of a debt issuer to make timely payments of principal and interest. Ratings of AAA (the highest), AA, A, and BBB are investment-grade quality. Ratings of BB, B, CCC, CC, C and D (the lowest) are considered below investment grade, speculative grade, or junk bonds.
Yield Curve – A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.
Yield to Maturity – The rate of return anticipated on a bond if it is held until maturity date. FPO FSC
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