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 managementOverall 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 neededIf 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

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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 theportfolio to purchase higher-yielding securities as interest ratesgo up. This is more difficult for a bond-ladder investor whois 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 opportunitiesto 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 mentalaccounting bias and lead them to a rational and optimalcash-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 ofthe 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 profileof the bond ladder? — Changes in the shape of yield andcredit curves present higher expected return opportunities toinvestors who have the flexibility to re-position their portfolioalong these curves. Mutual funds are able to use inbound cashflows from investors to buy bonds that will purposefully alterthe risk profile of the portfolio when appropriate. This is muchmore difficult to do in a bond ladder as the cash needed topurchase longer or shorter duration bonds only becomes avail-able when one of the incumbent holdings matures or is soldat a potentially compromised price.

• Is implementation feasible? — In exchange for a small annualexpense ratio (in the range of 10-25 bps), you may be able tooffload the burden of having to answer the following questions:

– Will the bond portfolio be properly diversified? —A rough estimate for the institutional pricing threshold isapproximately $100k in trade size, meaning that an investorwith $2.5M could conceivably diversify across 25 bonds with-out paying the markups that small lot investors are typicallycharged.

– Do you have a fair trading cost structure? — It’s likely thattrades worth $100K and up will help lower trading costs butthis won’t always be the case. When determining whetheror not a bond ladder is appropriate, you’ll want to know thatyour trading costs are low enough to at least partially offset amutual funds’ annual expense ratio.

– How liquid is the portfolio? — In the event that yourclient has an emergency that requires cash from their fixedincome portfolio, a bond ladder investor is more likely tohave to sell bonds at a compromised price in order toget the needed liquidity.

FOR ADVISOR USE ONLY

3 — Pros and Cons: Laddered Bonds & Total Return Strategies

– Can you re-invest coupons? — When a mutual fundaccumulates interest from coupon payments, the dollaramounts are usually large enough to re-invest in insti-tutional-sized trades. An investor using a bond ladderwith smaller dollar amounts may suffer cash drag asthe cash from coupon payments is often too small toaccommodate 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.

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