Download Bond ladders may not be the best investment strategy

Wells Fargo Funds
May 2017
Bond ladders may not be
the best investment strategy
By Jim Kochan, Chief Fixed-Income Strategist
Wells Fargo Funds Management, LLC
For investors seeking income from municipal bond exposure, one of the most popular
investment strategies employed by individual investors has been one of the least
successful strategies—the bond ladder. It’s a simple investment plan—individually owned
municipal bonds bought at increasing maturity ranges like rungs on a ladder produce
predictable income streams and have predictable end-date values when held to maturity.
What makes the ladders preferable for some investors over actively managed portfolios
is the notion that if the bonds are held to maturity, investors need not be concerned with
fluctuations in their market values during the holding period as they are believed to be
less exposed to market risk. However, even when a ladder is held to maturity, it may still
underperform a more broadly diversified investment strategy; therefore, it’s typically not
the best investment strategy for every investor.
Simply put, the comforts and predictable assurances of the ladder strategy may lead to investors missing
out on better investment options from broadly diversified strategies and actively managed portfolios. For
example, as shown in Table 1, the average annual yield over the past five years from a ladder of 10 AAArated municipal bonds evenly distributed from the 1-year to the 10-year maturity was 1.40%. That’s notably
less than the average annual return of 3.50% from the broadly diversified Bloomberg Barclays Municipal
Bond Index over the past five years. Over the full five-year investment period, this translates to a cumulative
return of approximately 7% for the ladder and 18% for the market index—a substantial difference. There are
several reasons for the lower yields of bond ladders. Our research finds two primary causes:
1. Actively managed portfolios typically are more broadly diversified, allowing for investment across
various credit-quality tiers and maturity ranges while allowing for timely adjustments for changing
market conditions.
2. Buying individual bonds for a ladder is often more expensive than buying large blocks of bonds
for a fund.
FOR INVESTMENT PROFESSIONAL USE ONLY – NOT FOR USE WITH THE RETAIL PUBLIC
Table 1a | Municipal indexes
The results confirmed that
the average annual yields of
the modeled bond ladders
were lower than the annual
returns of the broadly
diversified municipal bond
indexes and would have
significantly underperformed
those indexes in the most
recent years.
Table 1b | AAA municipal bond
ladders: Based on
institutional pricing1
Avg. annual
returns (%)
2 yr.
5 yr.
Ladders
rolled annually
(as of 4-15-17)
2.30
1.16
1.23
5-year ladder
Municipal Short-Int.
1 -10 Years Index
3.60
1.61
1.95
7-Year Municipal Bond
Index (6 -8 years)
5.20
2.10
2.71
Municipal Bond Index
6.75
2.65
3.50
Bloomberg Barclays
index (as of 4-15-17)
Municipal Short-Term
Index (1–5 years)
Approx.
duration
(yrs.)
Approx.
duration
(yrs.)
Avg. annual
yields* (%)
2 yr.
5 yr.
2.90
0.85
0.86
7-year ladder
3.90
1.03
1.09
10-year ladder
5.10
1.27
1.40
*Yields for ladders are represented by Bloomberg’s fair-value composites.
Source: Bloomberg Barclays
Past performance is no guarantee of future results. This analysis does not include the fees, expenses, and sales
charges that would be applicable when purchasing a municipal bond fund. This chart is for illustration only and
does not predict or guarantee the performance of any Wells Fargo Fund. You cannot invest directly in an index.
To investigate these observations, we compared the yields from several municipal
bond ladder strategies with the returns from municipal bond indexes, which are
typically more broadly diversified in terms of both maturity and credit quality. We
modeled several different municipal bond ladders and rolled them for periods of the
past two years and five years. The results confirmed that the average annual yields
of the modeled bond ladders were lower than the annual returns of the broadly
diversified municipal bond indexes and would have significantly underperformed
those indexes in the most recent years.
The major changes in the fixed-income markets since the onset of the financial crisis
in 2007 were important contributors to the poor performance of laddered portfolios.
In the municipal market, yield curves have stayed relatively steep and quality spreads
have become been much wider than before 2008. Those developments have penalized
holders of the top-quality shorter maturities. In addition, yield differentials between
bonds purchased in small lots and bonds purchased in institutional-sized lots are much
greater now than precrisis. Those changes typically favor large-scale institutionally
managed portfolios over relatively small portfolios assembled for individual investors.
Of course, the amount an investor benefits from this institutional pricing advantage
would be reduced by any fees, expenses, or sales charges.
1. Institutional pricing within this paper is defined as the market-quoted yield on Bloomberg, which is often only fully
attainable through large block trades (greater than $200,000) of fixed-income securities.
2
AAA-rated municipal bond ladders
underperformed the municipal bond indexes
There are many ways to build a bond ladder—we modeled some of the more typical
types of ladders that have rungs of 5-year, 7-year, and 10-year maturities (see Table 1b).
In all of these cases, the broadly diversified indexes outperformed the bond ladders.
This is just a sample of the benefits that a broadly diversified portfolio can provide.
Because the indexes are passive, not actively managed mutual funds, the index returns
are only estimates of the potential benefits from broad diversification. An actively
managed fund has the potential to outperform the indexes and to even further
outperform the ladders. That’s because the indexes cited here include AAA-rated
municipal bonds. Many managers of municipal bond funds employ teams of credit
analysts, which allows them to build portfolios containing mostly A-rated and BBBrated issues. They might own few if any AAA-rated credits. Because yields on A-rated
and BBB-rated credits are substantially greater than AAA-rated bond yields, those
managed portfolios would be expected to produce incrementally greater returns.
Tables 1a and 1b show the returns of various municipal indexes versus the yields of
various AAA-rated municipal ladders. Approximate durations are shown to provide
some context of comparison for the ladders against the municipal indexes. In practice,
investors typically build 5-year or 10-year ladders, and thus a comparison with the
shorter-duration municipal indexes would be more appropriate.
As shown in the tables, in every case the average annual return of the municipal index
exceeded the average annual yield of the corresponding bond ladder of similar
duration across both the 2-year and 5-year time periods.
As shown in the tables,
in every case the municipal
index exceeded the
average annual yield
of a corresponding bond
ladder of similar duration.
Buying in bulk is often cheaper
per unit than buying individually
In a market as diverse and complex as the municipal bond market, the institutional
investor very often has several advantages over individual investors when acquiring
securities. If an attractive new issue comes to market, portfolio managers who
purchase in $1 million or larger amounts will very often acquire all the bonds, leaving
none for individuals who would be willing to buy $20,000 to $50,000 of the issue. By
extension, bonds that do become available to the individual investor might not be
as attractive.
Another advantage is price. Because it is less costly to sell large blocks ($1 million
or more) than small blocks of securities, the buyer of large blocks is often able to
negotiate a lower price/higher yield. This is often true in all sectors of the global bond
markets—especially in the municipal market where individual investor purchases
can be relatively small. For example, according to Municipal Securities Rulemaking
Board reports from April 12, 2017, one AA-rated state general obligation bond traded
in blocks ranging from $20,000 to more than $1 million. The $20,000 block traded
at $103.276 at the same time the $1 million block traded at $101.233, an immediate
price advantage of more than 2% for the large institutional investor. On a purchase
of $20,000, a two-point price differential translates to a $400 cost differential.
3
Conclusion
The perception of predictable assurances of bond ladder strategies may seem
appealing but may result in missed opportunities for better investment return
potential in actively managed portfolios. The differences in potential return
between laddered strategies and broadly diversified index strategies become
even greater when yields on the highest-quality and shortest-term bonds are
well below those of the lower-rated and longer-term issues, as they have been
over the past two years. Bond ladders typically are not invested in the lower
credit spectrum or the longer maturity range and are usually not flexible
enough to respond quickly to changing market conditions. Consequently,
modeled bond ladders have significantly underperformed diversified municipal
bond indexes since the financial crisis.
Finally, it’s important to note that the bond market is a competitively priced
landscape with varying opportunities for investment. Buying individual bonds for
a ladder is often more expensive than buying large blocks of bonds for a fund.
Thus, investors may benefit from investing with a fund manager who is buying
bonds in bulk rather than purchasing them individually, as long as the fees,
expenses, and sales charges do not offset the bulk pricing advantage. In the bond
world, a better price means a better yield. For these reasons as well as others,
building a bond ladder of individually purchased bonds may not always be the
best investment option.
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rates rise, bond values fall and investors may lose principal value. Certain investment
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