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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. For additional information or literature: Call:1-888-877-9275 Email:[email protected] Write:Wells Fargo Funds P.O. Box 8266 Boston, MA 02266-8266 Visit:wellsfargofunds.com The views expressed and any forward-looking statements are as of 4-21-17 and are those of the authors and/or Wells Fargo Funds Management, LLC. Discussions of individual securities, the markets generally, or any Wells Fargo Fund are not intended as individual recommendations. Future events or results may vary significantly from those expressed in any forward-looking statements; the views expressed are subject to change at any time in response to changing circumstances in the market. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements. Bond values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. In general, when interest rates rise, bond values fall and investors may lose principal value. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). Consult a fund’s prospectus for additional information on these and other risks. A portion of a fund’s income may be subject to federal, state, and/or local income taxes or the alternative minimum tax (AMT). Any capital gains distributions may be taxable. Carefully consider a fund’s investment objectives, risks, charges, and expenses before investing. For a current prospectus and, if available, a summary prospectus, containing this and other information, call 1-888-877-9275 or visit wellsfargofunds.com. Read it carefully before investing. Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. Wells Fargo Funds Management, LLC, a wholly owned subsidiary of Wells Fargo & Company, provides investment advisory and administrative services for Wells Fargo Funds. Other affiliates of Wells Fargo & Company provide subadvisory and other services for the funds. The funds are distributed by Wells Fargo Funds Distributor, LLC, Member FINRA, an affiliate of Wells Fargo & Company. Neither Wells Fargo Funds Management nor Wells Fargo Funds Distributor has fund customer accounts/assets, and neither provides investment advice/ recommendations or acts as an investment advice fiduciary to any investor. 303189 05-17 FOR INVESTMENT PROFESSIONAL USE ONLY – NOT FOR USE WITH THE RETAIL PUBLIC © 2017 Wells Fargo Funds Management, LLC. All rights reserved. FAPOS29 05-17