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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. 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 outperform other bond strategies because it simultaneously accomplishes two goals:
• Captures price appreciation as the bonds age and their remaining life shortens.
• Reinvests principal from maturing limited-term bonds (low yielding bonds) into new longer-term bonds (high 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 is achieved by maintaining an investment of approximately six to ten percent of a bond portfolio in each year of the selected maturity range.
We believe that two durations of ladders provide the best results:
•
A limited-term ladder in which the average maturity is kept between three and five years.
• An intermediate-term ladder with an average maturity between six and ten years.
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. 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.
More Examples
Compare 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 (the bond’s sensitivity to interest rates) after five years of aging.
| Length of Bond | Initial Duration |
Duration After Five Years |
Change in Duration | % Change in Duration |
|---|---|---|---|---|
| 30-year | 15.5 | 14.2 | -1.3 | -8% |
| 20-year | 12.6 | 10.5 | -2.1 | -17% |
| 10-year | 7.8 | 4.4 | -3.4 | -44% |
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.
The illustration on the right shows the price of an intermediate municipal 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. The illustration below demonstrates how a ladder can be expected to react to three interest rate scenarios:
• Unchanged Interest Rates
(The center line in the graph below represents 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 below represents rising 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, high 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 above represents falling 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 long-term 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 municipal bond yield curve (shown in the chart below) for three years from 2004—2006. 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 rise substantially every year for the first 10 years of the curve in the municipal market.
As the chart 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 becomes virtually flat, and little or no 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 limited and intermediate 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 the 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. 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 long-term 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.
Summary
Laddering short and intermediate bonds captures most of the return of longer 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 5-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.
The views expressed by the Portfolio Managers reflect their professional opinions and are subject to change.
Bonds 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.
The laddering strategy does not assure or guarantee better performance and cannot eliminate the risk of investment losses.
About the Authors
George Strickland
Co-Portfolio Manager and Managing Director
George Strickland is a managing director and co-portfolio manager of the Thornburg municipal bond portfolios. He is responsible for overseeing the -research, trading, and strategic positioning of municipal bond portfolios. Thornburg municipal bond portfolios have won a number of awards from independent rating services. They include two national funds, three single state funds, and numerous separate accounts.
George joined Thornburg Investment Management as an associate portfolio manager in 1991, and was elected managing director in 1996. Prior to joining Thornburg, George began his financial career with the Calvert Group and has his BA in Economics from Davidson College and his MBA in Finance from the University of Maryland.
Josh Gonze
Co-Portfolio Manager and Managing Director
Josh Gonze is a managing director and co-portfolio manager for Thornburg municipal bond portfolios. He is responsible for credit analysis for new bond transactions, monitoring credit quality within the portfolios, and evaluation of sector-wide credit trends. His scope of activity includes assessment of industry, business, and financial risk, including calculation of financial and operating ratios. He also assists in trading bonds for both the mutual funds and private accounts.
Josh joined Thornburg Investment Management in 1999, and was named managing director in 2003 and promoted to co-portfolio manager in 2007. 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 Ihlefeld
Co-Portfolio Manager and Managing Director
Christopher Ihlefeld is a managing director and co-portfolio manager of Thornburg municipal bond portfolios. Christopher specializes in the trading, monitoring, and structuring of municipal bond portfolios.
Christopher joined Thornburg Investment Management as a dealer services representative in 1996. Prior to joining the portfolio management team he served at Thornburg as an information technology specialist and program analyst. In 2006, Christopher was named managing director and in 2007, he was promoted to co-manager. Christopher holds a BA in Liberal Arts from Rollins College and an MBA in Finance from the College of Santa Fe.
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