Most choose investment-grade securities in their laddered bond portfolios, but ETFs can free investors from that mold
Uncertainty appears to be the order of the day for the bond markets. As indicators of economic strength and developments on the geopolitical front continue to clash and shift, it’s difficult for policymakers and analysts alike to settle on a firm stance, much less agree on a single trajectory for interest rates.
In the midst of this uncertainty, fixed-income investors are forced to consider their defensive options. Floating-rate products mitigate some interest-rate risk, while focusing on the short end of the curve can also be beneficial. Another option is to use defined-maturity bond ETFs that, unlike traditional fixed-income funds, seek to hold securities to maturity; at that point, investors may either collect the proceeds from the maturing funds or reinvest in a different ETF with a new maturity date.
An extension of that approach, however, may allow fixed-income investors to take a well-used strategy to potentially more lucrative lengths. “Bond laddering is a popular strategy among investors seeking steady returns and income, particularly when interest rate conditions are uncertain,” said Karen Schenone, CFA and fixed income product strategist at BlackRock, in a recent note.
The practice of laddering, Schenone explained, involves building a portfolio of bonds that will mature in consecutive calendar years. Any maturing principal from that portfolio is reinvested into new bonds that extend the ladder out another year.
“Defined-maturity bond exchange traded funds (ETFs) … make building bond ladders more efficient by combining the control of investing in individual bonds with the convenience and diversification of an ETF,” she said. Rather than buying single bonds with successive maturity dates, investors could purchase defined-maturity ETFs, gaining exposure to hundreds of underlying bonds with known maturity dates, potential for monthly income, and a portfolio management experience that’s overall more convenient than do-it-yourself bond selection.
That simplicity also opens the door to investment through high-yield bond securities, as opposed to the investment-grade and municipal issues to which ladder investors tend to restrict themselves. That option may very well be tempting for those unimpressed with the income currently offered by munis and investment-grade corporate bonds; according to Schenone, the yields to worst for the Bloomberg Barclays December 2021-2025 Maturity Corporate Indexes are contained between 2% and 4%, whereas yields to worst for the Bloomberg Barclays 2021-2025 Term High Yield and Income Indexes exceed 4% and can even go past 6%.
“[S]ecurity selection becomes even more important for a high-yield bond ladder, since these bonds have higher credit or default risk than investment-grade securities,” Schenone cautioned. And referring to the Bloomberg Barclays US High Yield Bond Index, she said more than 80% of the high-yield bond market is callable, creating the possibility that the issuer will return the money early.
“If a bond gets called early, investors will have to reinvest the money in another bond, potentially at a different interest rate,” she said. “[T]hat uncertainty can make it difficult to maintain a steady cash flow and specific maturities as they move ‘up the ladder.’”
But with certain high-yield and income ETFs, portfolio managers have the flexibility to include BBB-rated bonds under certain market conditions. Since such bonds have a much lower likelihood of getting called, their inclusion would help the fund to mature at a set date in case the high-yield holdings get called.