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Laddered bonds pros_and_cons

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Better Financial Education
Better Financial Education

This document provides information on bond ladders and total return strategies for investors. It summarizes the pros and cons of each approach. A bond ladder can match liabilities but lacks diversification and yield is slow to rise with interest rates. A total return strategy has a greater likelihood of maintaining purchasing power over time but returns will vary each year. The document also discusses when each approach may be suitable based on an investor's objectives, such as liability-driven investing, principal protection, or needing regular income. It concludes that a bond ladder is only appropriate if the investor can dynamically manage risk, implement the strategy in a diversified and liquid manner.

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Are your clients asking you about bonds? Matt Carvalho, CFA, CFP®, Director of Investment Research, provides some helpful information you can share about bond ladders and total return strategies. Laddered Bonds Pros Cons Can match liabilities Concentration risk / lack of diversification Smoother yield over time Trading costs May allow for more precise tax management Overall yield is very slow to catch up with rising interest rates Not a good hedge against inflation May not be very liquid (without significant discounts in price of bonds being sold) Total Return Pros Cons Greater likelihood of maintaining purchasing power over long run Coupons are not perfectly steady each year Ability to take taxable gains only when needed If equity premium does not occur, it would underperform Diversification to all bond strategy (small amount of equities can potentially lower standard deviation of an all bond portfolio) Wider range of possible future values There are situations where a bond ladder may be an appropriate strategy, provided that it truly helps the client meet their investment objective and their portfolio size is large enough to efficiently implement the strategy. For most investors weighing this decision, their investment objectives typically fall into one of three categories: Liability-Driven Investing A portfolio of laddered bonds might give individual investors the ability to match bond cash flows with pre-determined long-term obligations that won’t change with inflation. This strategy is effective for large institutions with a defined-benefit obligation. However, most individual investors’ liabilities are exposed to inflation, and their timing and magnitude isn’t predeter- mined — making a total return objective more suitable for their needs. Pros and Cons Laddered Bonds & Total Return Strategies Reviewed by Better Financial Education
2 — Pros and Cons: Laddered Bonds &Total Return Strategies Principal Protection Investors with this objective often incorrectly assume that a bond ladder, providing the flexibility to hold bonds until maturity and receive full principal, will be more effective than a bond fund as a means of principal protection. A mutual fund also has the ability to do this if it is in the shareholder’s best interests. Likewise, in a rising rate environment, a mutual fund has two advantages that a bond ladder may not necessarily have: • A mutual fund can use inbound cash flows to reposition the portfolio to purchase higher-yielding securities as interest rates go up. This is more difficult for a bond-ladder investor who is already fully invested. • Mutual funds are typically better at providing broad diversi- fication, minimizing their exposure to issuer-specific risk. Addressing Need for Regular Income Investors are often drawn to the predictable stream of cash flows that a portfolio of individual bonds provides; however, this can actually be detrimental to their long-term investment goals. I’ve provided a couple of resources to help you frame a discussion around this: In a paper titled, “A Synthetic Dividend,” Gene Fama explains why an emphasis on high cash-flow generating fixed income investments may not provide the best portfolio-level results. He highlights the following ideas: • Emphasize “total portfolio return” versus periodic investment- driven cash flow. Taking this approach provides opportunities to add value to the portfolio management experience: – Dividend vs. Capital Gain tax rates – Opportunities to rebalance portfolio – Tax-loss harvesting Brad Steiman, Director of Dimensional Fund Advisors Canada, provides additional perspective on the topic in an article titled, “Income or Cash Flow:” • Determine the source of the income need (recurring liability, need for self-control) to help the client overcome mental accounting bias and lead them to a rational and optimal cash-flow management decision. Regardless of the investor’s objective, there are trade-offs that an investor must consider as they compare a replenishing ladder strategy to a bond mutual fund. The bond ladder strategy is only appropriate if they can answer each of the following questions in the affirmative: • Will you be able to dynamically manage the risk profile of the bond ladder? • Is implementation feasible? Consider the following trade-offs: – Will the bond ladder be properly diversified? – Do you have a fair trading cost structure? – How liquid is the portfolio? – Can you reinvest coupons? In order to help think about answers to each of the questions above, I’ve provided additional considerations on each idea below: • Will you be able to dynamically manage the risk profile of the bond ladder? — Changes in the shape of yield and credit curves present higher expected return opportunities to investors who have the flexibility to re-position their portfolio along these curves. Mutual funds are able to use inbound cash flows from investors to buy bonds that will purposefully alter the risk profile of the portfolio when appropriate. This is much more difficult to do in a bond ladder as the cash needed to purchase longer or shorter duration bonds only becomes avail- able when one of the incumbent holdings matures or is sold at a potentially compromised price. • Is implementation feasible? — In exchange for a small annual expense ratio (in the range of 10-25 bps), you may be able to offload the burden of having to answer the following questions: – Will the bond portfolio be properly diversified? — A rough estimate for the institutional pricing threshold is approximately $100k in trade size, meaning that an investor with $2.5M could conceivably diversify across 25 bonds with- out paying the markups that small lot investors are typically charged. – Do you have a fair trading cost structure? — It’s likely that trades worth $100K and up will help lower trading costs but this won’t always be the case. When determining whether or not a bond ladder is appropriate, you’ll want to know that your trading costs are low enough to at least partially offset a mutual funds’ annual expense ratio. – How liquid is the portfolio? — In the event that your client has an emergency that requires cash from their fixed income portfolio, a bond ladder investor is more likely to have to sell bonds at a compromised price in order to get the needed liquidity. FOR ADVISOR USE ONLY
3 — Pros and Cons: Laddered Bonds &Total Return Strategies – Can you re-invest coupons? — When a mutual fund accumulates interest from coupon payments, the dollar amounts are usually large enough to re-invest in insti- tutional-sized trades. An investor using a bond ladder with smaller dollar amounts may suffer cash drag as the cash from coupon payments is often too small to accommodate institutional-sized purchases. Implementing a total return income portfolio cannot guarantee a gain or protect against a loss. Diversification neither assures a profit nor guarantees against loss in a declining market. Investing in mutual funds involves risk, including the loss of principal. Before investing in any fund, please carefully read the prospectus, which includes information concerning the fund’s investment objectives, risks, and charges and expenses. Bonds are subject to market and interest rate risk. Bond values will decline as interest rates rise, issuer’s creditworthiness declines, and are subject to availability and changes in price. The material in this communication is provided solely as back- ground information for registered investment advisors and is not intended for public use. Unauthorized copying, reproducing, duplicating, or transmitting of this material prohibited. The opinions expressed on third-party websites and articles are those solely of the author(s) and do not necessarily reflect the views of LWI Financial Inc. (“Loring Ward”) or its affiliates. Reviewed by Better Financial Education LWI Financial Inc. (“Loring Ward”) is an investment adviser registered with the Securities and Exchange Commission. Securities transactions are offered through its affiliate, Loring Ward Securities Inc., member FINRA/SIPC. R 13-358 (Exp 10/15)

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Laddered bonds pros_and_cons

  • 1. Are your clients asking you about bonds? Matt Carvalho, CFA, CFP®, Director of Investment Research, provides some helpful information you can share about bond ladders and total return strategies. Laddered Bonds Pros Cons Can match liabilities Concentration risk / lack of diversification Smoother yield over time Trading costs May allow for more precise tax management Overall yield is very slow to catch up with rising interest rates Not a good hedge against inflation May not be very liquid (without significant discounts in price of bonds being sold) Total Return Pros Cons Greater likelihood of maintaining purchasing power over long run Coupons are not perfectly steady each year Ability to take taxable gains only when needed If equity premium does not occur, it would underperform Diversification to all bond strategy (small amount of equities can potentially lower standard deviation of an all bond portfolio) Wider range of possible future values There are situations where a bond ladder may be an appropriate strategy, provided that it truly helps the client meet their investment objective and their portfolio size is large enough to efficiently implement the strategy. For most investors weighing this decision, their investment objectives typically fall into one of three categories: Liability-Driven Investing A portfolio of laddered bonds might give individual investors the ability to match bond cash flows with pre-determined long-term obligations that won’t change with inflation. This strategy is effective for large institutions with a defined-benefit obligation. However, most individual investors’ liabilities are exposed to inflation, and their timing and magnitude isn’t predeter- mined — making a total return objective more suitable for their needs. Pros and Cons Laddered Bonds & Total Return Strategies Reviewed by Better Financial Education
  • 2. 2 — Pros and Cons: Laddered Bonds &Total Return Strategies Principal Protection Investors with this objective often incorrectly assume that a bond ladder, providing the flexibility to hold bonds until maturity and receive full principal, will be more effective than a bond fund as a means of principal protection. A mutual fund also has the ability to do this if it is in the shareholder’s best interests. Likewise, in a rising rate environment, a mutual fund has two advantages that a bond ladder may not necessarily have: • A mutual fund can use inbound cash flows to reposition the portfolio to purchase higher-yielding securities as interest rates go up. This is more difficult for a bond-ladder investor who is already fully invested. • Mutual funds are typically better at providing broad diversi- fication, minimizing their exposure to issuer-specific risk. Addressing Need for Regular Income Investors are often drawn to the predictable stream of cash flows that a portfolio of individual bonds provides; however, this can actually be detrimental to their long-term investment goals. I’ve provided a couple of resources to help you frame a discussion around this: In a paper titled, “A Synthetic Dividend,” Gene Fama explains why an emphasis on high cash-flow generating fixed income investments may not provide the best portfolio-level results. He highlights the following ideas: • Emphasize “total portfolio return” versus periodic investment- driven cash flow. Taking this approach provides opportunities to add value to the portfolio management experience: – Dividend vs. Capital Gain tax rates – Opportunities to rebalance portfolio – Tax-loss harvesting Brad Steiman, Director of Dimensional Fund Advisors Canada, provides additional perspective on the topic in an article titled, “Income or Cash Flow:” • Determine the source of the income need (recurring liability, need for self-control) to help the client overcome mental accounting bias and lead them to a rational and optimal cash-flow management decision. Regardless of the investor’s objective, there are trade-offs that an investor must consider as they compare a replenishing ladder strategy to a bond mutual fund. The bond ladder strategy is only appropriate if they can answer each of the following questions in the affirmative: • Will you be able to dynamically manage the risk profile of the bond ladder? • Is implementation feasible? Consider the following trade-offs: – Will the bond ladder be properly diversified? – Do you have a fair trading cost structure? – How liquid is the portfolio? – Can you reinvest coupons? In order to help think about answers to each of the questions above, I’ve provided additional considerations on each idea below: • Will you be able to dynamically manage the risk profile of the bond ladder? — Changes in the shape of yield and credit curves present higher expected return opportunities to investors who have the flexibility to re-position their portfolio along these curves. Mutual funds are able to use inbound cash flows from investors to buy bonds that will purposefully alter the risk profile of the portfolio when appropriate. This is much more difficult to do in a bond ladder as the cash needed to purchase longer or shorter duration bonds only becomes avail- able when one of the incumbent holdings matures or is sold at a potentially compromised price. • Is implementation feasible? — In exchange for a small annual expense ratio (in the range of 10-25 bps), you may be able to offload the burden of having to answer the following questions: – Will the bond portfolio be properly diversified? — A rough estimate for the institutional pricing threshold is approximately $100k in trade size, meaning that an investor with $2.5M could conceivably diversify across 25 bonds with- out paying the markups that small lot investors are typically charged. – Do you have a fair trading cost structure? — It’s likely that trades worth $100K and up will help lower trading costs but this won’t always be the case. When determining whether or not a bond ladder is appropriate, you’ll want to know that your trading costs are low enough to at least partially offset a mutual funds’ annual expense ratio. – How liquid is the portfolio? — In the event that your client has an emergency that requires cash from their fixed income portfolio, a bond ladder investor is more likely to have to sell bonds at a compromised price in order to get the needed liquidity. FOR ADVISOR USE ONLY
  • 3. 3 — Pros and Cons: Laddered Bonds &Total Return Strategies – Can you re-invest coupons? — When a mutual fund accumulates interest from coupon payments, the dollar amounts are usually large enough to re-invest in insti- tutional-sized trades. An investor using a bond ladder with smaller dollar amounts may suffer cash drag as the cash from coupon payments is often too small to accommodate institutional-sized purchases. Implementing a total return income portfolio cannot guarantee a gain or protect against a loss. Diversification neither assures a profit nor guarantees against loss in a declining market. Investing in mutual funds involves risk, including the loss of principal. Before investing in any fund, please carefully read the prospectus, which includes information concerning the fund’s investment objectives, risks, and charges and expenses. Bonds are subject to market and interest rate risk. Bond values will decline as interest rates rise, issuer’s creditworthiness declines, and are subject to availability and changes in price. The material in this communication is provided solely as back- ground information for registered investment advisors and is not intended for public use. Unauthorized copying, reproducing, duplicating, or transmitting of this material prohibited. The opinions expressed on third-party websites and articles are those solely of the author(s) and do not necessarily reflect the views of LWI Financial Inc. (“Loring Ward”) or its affiliates. Reviewed by Better Financial Education LWI Financial Inc. (“Loring Ward”) is an investment adviser registered with the Securities and Exchange Commission. Securities transactions are offered through its affiliate, Loring Ward Securities Inc., member FINRA/SIPC. R 13-358 (Exp 10/15)