Bond ladders are yesterday's way to invest in bonds. They limit investment returns and increase your default risk, but thousands of
investors and financial advisors follow the bond ladder herd and this investment sin. Why?
Why do bond ladder investors believe a bond's maturity date should be the primary investment criterion?
Why do bond ladder investors want to cap their returns at a bond's yield to maturity and take capital appreciation off the table?
Why do bond ladder investors 'set it and forget it' when they build a new bond ladder and fail to keep tabs on the bonds and bond issuers contained in each rung of the ladder?
COVID-19 Crisis Shows Why Bond Ladders Are a Bad Idea
Why do bond ladder investors want to put a lot of money to work at once rather than take advantage of bond investment opportunities over time? The fall in many corporate bond prices in the midst of the COVID-19 crisis in March 2020 illustrates this specific point. If an investor built a bond ladder between September 2019 and February 2020, he would have invested when bond prices were very high and bond yields were low. In addition, since he likely put a good chunk of money into this newly built bond ladder, he didn't have any money left to take advantage when corporate bond prices fell in the midst of the COVID-19 crisis. BondSavvy's investment strategy focuses on maximizing capital appreciation and total return. Being able to buy bonds when markets fall is a big part of maximizing investment returns.
Many of the corporate bond investment opportunities available in March 2020 have never been seen before. Some Apple bonds even fell 30 points before quickly recovering. Investors using our active approach to bond investing can take advantage of the market when prices fall, but bond ladders cannot. We discuss how bond ladders attempt to time the market later in the post.
Most online brokerages have sophisticated tools to build bond ladders. And the small number of financial advisors who invest their clients' money in individual bonds rather than bond funds -- a good thing -- continue to commit the sin of building bond ladders because, well, "that's the way we've always done it here."
As we discuss in this blog post, bond ladders have many disadvantages and should be avoided by investors in favor of an active approach to bond investing. BondSavvy's focus is corporate bonds, and corporate bonds are the focus of this post; however, many of the same concepts can be applied to investing in municipal bonds and Treasury bonds. That said, out of municipal, Treasury, and corporate bonds, we believe corporate bonds are best suited to active investing.
BOND LADDER EXAMPLE
So how do bond ladders work? It starts with the assumption that the best way to select bonds is based primarily on a bond's maturity date: not the value of the bond relative to comparable bonds, the prospects of the issuer, or whether the bond's price can increase. Builders of bond ladders disregard this analysis and, instead, focus on maturity date. So here's how bond ladders work:
In Figure 1, an investor buys $100,000 face value of bonds (100 bonds) and creates a laddered bond portfolio where the bonds in the portfolio mature at different dates. In the below example, the investor buys 30 bonds that mature in 2023, 40 bonds that mature in 2026, and 30 bonds maturing in 2028. When the bonds on each rung of the bond ladder mature, the investor will then buy more bonds at different bond maturity dates.
Figure 1: Bond Ladder Example (Green = Buys; Orange = Bonds Maturing)
The bond ladder strategy has many weaknesses, which we will discuss in turn. We also later discuss active bond investing, which we believe is a better alternative to building laddered bond portfolios.
BOND LADDER DISADVANTAGES
Bond Ladders Seek To Time the Market
Investors building bond ladders typically invest a significant portion of money when they build a new bond ladder. When investors do this, they are effectively trying to time the market since they are anointing the day they create the bond ladder as the best time to invest in bonds. The problem with this approach is that bond prices within an investment portfolio will move up and down over time. For example, investment-grade bonds are generally more sensitive to changes in interest rates while high-yield bonds are more dependent on the creditworthiness of the issuer. Interest rates and the credit quality of specific issuers do not move in lock step, so investing all at once precludes investors from taking advantage of situations when buying opportunities arise.
Bond Maturity Dates Are a Bond Ladder's Primary Investment Criterion
A bond's maturity date is one of many factors impacting a bond investment decision. In the bond ladder, however, it is the primary investment criterion. In the Figure 1 bond ladder example, the first rung on the bond ladder is 2023. As a result, when this bond ladder was built, finding bonds that matured in this specific year was the most important goal. The problem with this approach is: who's to say that a bond maturing in 2023 is a better investment than a bond maturing in 2024 or 2030? Building a bond ladder takes key considerations such as the company's recent and projected financial performance, the price of the bond relative to par value, and the yield of the bond relative to other comparable bonds out of the investing equation. We consider all of these factors plus a bond's maturity date when making corporate bond investment recommendations for BondSavvy subscribers.
Bond Ladders Cap Investment Returns at a Bond's Yield to Maturity
Investors have been led to believe that they should always hold bonds to maturity. The problem with this is that it assumes that bond prices are static and only move on a straight line to par value at maturity. This assumption couldn't be further from the truth, as corporate bond prices are always moving. Since bond ladder investors always hold bonds to maturity, they can never achieve a return higher than a bond's yield to maturity. In some cases, since bond ladders are typically created without regard to a bond's price, they could achieve a return lower than the yield to maturity if the ladder invests in a bond priced at a premium to par value and the bond is called prior to maturity.
We show later in this post how selling bonds prior to maturity can achieve returns higher than a bond's yield to maturity and discuss our approach to selling bonds in this previous blog post.
Buying in at a good price when investing in bonds is just as important as it is when investing in stocks, as achieving capital appreciation is a key part of maximizing total returns and ensuring tax efficiency. While many investors may hold bond investments in an IRA account, for those holding bonds in a taxable investment account, $1 of capital appreciation is worth substantially more than $1 of interest income due to the more-favorable tax treatment of long-term capital gains. To maximize capital appreciation, we need to invest opportunistically as bonds priced at compelling values present themselves in the market. This doesn't happen all at once and on the same day, which is why the bond ladder 'big bang' approach does not enable investors to maximize capital appreciation and total returns. Further, since bond ladders favor interest income over capital appreciation, they can limit the tax efficiency of an investor's portfolio.
Bond Ladder Investors Have Higher Default Risk
We believe a bond ladder strategy is a complacent investing approach where the bond ladder owner effectively 'sets it and forgets it' and puts his head in the sand. This can be a risky approach to bond investing, as events will happen over time that impact a bond's price and rationale for continuing to hold a bond. Bond defaults typically don't occur overnight, but it's important for investors to regularly monitor the performance of bonds in their portfolios as well as the performance of the issuing companies. This is a service BondSavvy provides subscribers, as we monitor all previously recommended bonds to understand if a company's credit quality has changed and whether subscribers should buy more of a previously recommended bond, hold, or sell. We believe this helps increase investment returns and reduce a bond investor's default risk.
Image licensed from Shutterstock
In addition, since a bond ladder strategy typically doesn't include financial analysis on the issuing company, it's difficult for the investor to assess the risk-reward opportunity of each bond investment. Bond ladder investors don't look under the hood, which is another reason why they have higher default risk. Many investors rely on bond credit ratings; however, thousands of companies have the same credit rating, and ratings often don't change for years. Credit ratings do not speak to the value of the investment or whether a specific bond has the opportunity to outperform the market. Further, bond ratings methodologies are flawed and often favor companies with worse credit metrics due to their size and revenue diversification, as we discuss in this blog post.
Since founding BondSavvy, we have been showing investors how they can achieve higher investment returns by owning a select portfolio of individual corporate bonds rather than bond funds and bond ETFs. We have also shown the many other advantages enjoyed by owners of individual bonds.
But, if we are saying a bond ladder strategy is weak, then what's a better way?
ACTIVE INVESTING FOR BONDS: A BETTER ALTERNATIVE
Active bond investing begins with three key principles: 1) new fixed income investment opportunities present themselves over time, 2) selling bonds prior to maturity can help increase returns, and 3) investment positions should be increased or decreased over time depending on changes in bond prices and the company's performance. Here's how it works:
Figure 2 shows an example of active corporate bond investing, which is markedly different from the bond ladder example shown above. With active bond investing, we make investments as opportunities present themselves over time (shown in green). We may then add to previous positions in the case of a bond falling in price but the issuer's credit quality either remaining the same or improving. In addition, we look to sell bonds prior to maturity (shown in orange) to maximize capital appreciation and total returns. Please read our blog post on how we decide when it is time to sell bonds.
Figure 2: Illustrative Example of Active Bond Investing
Figure 2 presents an illustrative example of active bond investing, but how does it work in real life and what investment returns can this bond investing strategy achieve?
ACTIVE BOND INVESTING CASE STUDY
There are a finite number of compelling US bond market investment opportunities. As a result, we don't believe in churning through investments by rapidly buying and selling. Rather, we seek to maximize the return of each bond investment we recommend over as long of a time period as possible. This investment time horizon is typically one to four years.
Figure 3 shows the performance of two investments BondSavvy founder Steve Shaw made prior to founding BondSavvy, which included Apple 3.85% 5/4/2043 (CUSIP 037833AL4) and Cablevision 5.875% 9/15/2022 (CUSIP 12686CBB4). They illustrate two key points:
1) How important it is to invest in bonds at a good price; and
2) How selling bonds prior to maturity can achieve returns that exceed a bond's yield to maturity
For the Apple 3.85% '43 bond, Steve bought the bonds at 85.07 on October 28, 2013 and then sold the bonds at 95.32 on May 9, 2018. With over 10 points of capital appreciation gained over a 4.5-year period, the investment achieved an annualized rate of return of 6.4% compared to the quoted yield to maturity of 4.8%. The 6.4% return is extremely compelling given the high credit quality of Apple. Arguably, Steve should have sold the bonds during 2016 at a higher price and an even higher return: Lesson Learned.
Steve bought the Cablevision 5.875% '22 bonds on December 8, 2015 at a price of 79.25. The bonds had fallen drastically in mid-September as the result of Altice announcing its proposed acquisition of the company, which raised concerns around the company's debt load. When he did his financial analysis, however, Steve saw a compelling risk-reward opportunity. Over time, the bonds performed well, increasing approximately 20 points and achieving an annualized investment return of 17.6% when Steve sold the bonds January 9, 2018 at 99.12. (Read our blog post on how we decide when to sell corporate bonds.)
We show the performance of the Apple and Cablevision investments in Figure 3. Please click here to see the investment returns generated by BondSavvy's corporate bond investment recommendations.
Figure 3: Steve Shaw's Investments in Apple and Cablevision Corporate Bonds
Source: FINRA market data
Achieving returns higher than a bond's yield to maturity is key to growing your investment portfolio. Plug numbers into any retirement calculator, and you'll see the difference several percentage points can make to your retirement planning and investment portfolio.
ACTIVE INVESTING VS. BOND LADDERS
The name of the game in investing is maximizing returns for the level of risk one takes. Active bond investors can outperform laddered bond portfolios since they can buy at compelling prices and sell bonds prior to maturity when a bond's capital appreciation has been maximized. In addition, active investors carefully consider all of the merits of a bond investment before investing, as shown in Figure 4. This not only helps increase investment returns but can lower default risk since the active investor is more familiar with the business of the issuing company and how its creditworthiness could improve or worsen over time.
Figure 4: Comparing Bond Ladders to Active Bond Investing
|Attribute||Bond Ladder Strategy||Active Bond Investing|
|New Investment Criteria||- Maturity date
- Yield to maturity
|- Company's recent and expected financial performance
- Pricing of the bond relative to comparable bonds
- Interest-rate environment and whether a bond is sensitive or not sensitive to interest rates
- Bond's maturity date
- Upcoming maturities of other bonds issued by same company
- Relative seniority of the bond in company's capital structure
- Thresholds of credit rating upgrade or downgrade and likelihood of either
- Headroom under financial covenants
- Issuance size and trading activity
|Return Opportunity||Capped at yield to maturity||Maximize capital appreciation and sell prior to maturity to achieve returns higher than a bond's YTM
|Initial Investment Size||Big Bang - Buy all at once||- Invest portions of amount allocated to corporate bonds over time as opportunities arise.
- Increase or decrease holdings of particular bonds based on bond-price and issuing-company performance
|Investment Holding Periods||Always until maturity||Typically, one to four years. Goal is to maximize a bond's return over as
long a time period as possible.