By Jason Bloom
Time to read: 3 min
Despite the surprising recent fall in interest rates, investors will eventually face the challenge of a rising rate environment. Bond laddering is a strategy used by generations of investors to help manage the risks associated with future changes in interest rates. Allow me to explain the potential benefits and risks of bond laddering, as well as some products that may help you achieve your fixed income goals.
A bond ladder is a portfolio of bonds that mature at staggered intervals across a range of maturities. If rates are rising, proceeds from each maturing rung of bonds can be reinvested in longer-dated bonds at higher rates. If rates fall or remain flat, bondholders will be forced to accept lower yields only on the portion of bonds that are maturing and being reinvested during the period.
One of the greatest benefits of buying an individual bond issue and holding it to maturity is the investor has insulated themselves from the negative effect of rising interest rates on the bond’s value. Generally speaking, an investor will receive par for the bond at maturity no matter how high rates have gone. Of course, owning an individual bond also subjects the investor to credit risk — if the issuer fails to make scheduled interest payments the value of the bond will likely fall.
Investors who hold a bond to maturity have locked in their total return – the only risk to this return is if the company defaults on their debt obligations. To help mitigate default risk, how many different bonds should an investor own to diversify a portfolio against an economic downturn or other event that prevents a company from repaying its debts?
Investors considering this question often ask, “How did investment grade corporate debt perform during the 2008-2009 global financial crisis and the recession that followed?”
Diversification1 played a key role. The chart below shows the range of outcomes that would have been generated by hypothetical, randomly selected portfolios of one to 70 bonds held to maturity during the market stress of 2006-2009. The blue line represents the best-case scenario for each portfolio, and the orange line represents the worst-case scenario.
As you can see, a random one-bond portfolio would have generated one of two possible outcomes. Either the bond successfully matures (blue line), returning the stated coupon and par value to the investor, or the bond defaults (orange line), and the investor experiences a significant loss of their investment. The upward path of the orange line nicely illustrates the value of diversification during this particular period of market stress — the return generated by the worst-case scenario gradually improves as the number of bonds held in the portfolio increases. The worst-case and best-case outcomes converge when a portfolio includes all 70 bonds.
As you can see, the 70-bond portfolio that included all the defaulted bonds from the sample universe delivered a total return only modestly below the originally stated yield of the portfolio.
Source: Barclays POINT. The study analyzed the bond universe defined by the Bloomberg Barclays 1-5 Year US Corporate Index and selected from the 70 bonds that matured during Q1 2009. These bonds were held to maturity starting in March 2006. For illustrative purposes only.
While bond laddering may be a helpful tool for investors, it has become markedly more difficult to implement in the decade since the financial crisis. Large banks that were the traditional sources of bonds for individual investors have drastically reduced the amount of bonds held in inventory. Also, achieving a desirable level of diversification in a bond portfolio requires significant time and research.
That’s where defined-maturity exchange-traded funds (ETFs) can help. Traditional bond ETFs usually sell bonds well before their final maturity dates and reinvest those proceeds into other bonds. But defined-maturity ETFs invest in a variety of bonds that all mature within a defined window of time. At the end of that window, proceeds are returned to investors, who can either spend them or reinvest them into longer-dated funds as rates increase.
In short, defined-maturity ETFs help investors build bond ladders quickly and easily while also helping to provide diversification. Investors interested in defined-maturity ETFs may wish to consider Invesco’s BulletShares suite of ETFs, which offers the choice of investment grade, high yield or emerging market bond exposure.
1 Diversification does not guarantee a profit or eliminate the risk of loss.
The Bloomberg Barclays 1-5 Year US Corporate Index includes US dollar-denominated, investment-grade, fixed-rate, taxable securities with maturities between one and five years.
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