Guy LeBas
Chief Fixed Income Strategist
August 11, 2020
Although the summer doldrums have settled in, the bulk of 2020 has proven to be anything but boring for financial markets.
TREASURY YIELDS
At time of publication, 10-year Treasury yields are hovering below 0.60%, which is the lowest they have been at any point in history (sustainably anyway; they fell below this level during the March meltdown).
Similarly, yields on corporate and municipal bonds are at all-time lows. While it is challenging to accept the lower levels of income new bond purchases generate today as opposed to, say, 12 months ago, it remains an unavoidable market fact. Just as importantly, low interest rates do not invalidate one of the classic fixed-income portfolio construction tools: The bond ladder.
BOND LADDER STRATEGY
Laddered investing refers to investing in the bond markets with a series of bonds with ascending maturity dates in regular intervals. Each maturity is akin to a rung on a ladder. For example, an evenly spaced $500,000 10-year ladder portfolio comprised of 10 bonds would have $50,000 bond maturities in year 1, 2, 3, and so on, with the final maturity coming in year 10.
Based on a generic mix of A-rated corporate bonds, such a ladder would yield about 0.8% today. There are ways to extend this ladder structure as well, with an income “boost” from a portion of the total portfolio in higher income-producing bonds. For example, that same portfolio might have $350,000 in bond maturities in years 1, 2, 3, and so on through 10, with the remaining $150,000 invested in 30-year bonds, lower- rated short-term bonds, or preferreds. That hypothetical ladder with a boost portfolio would yield as much as 1.6% today, a significant boost to the basic ladder example. That higher-yielding allocation can help combat low initial income generation from a bond ladder.
IS A BOND LADDER STRATEGY RIGHT FOR YOU?
More importantly, however, the lifetime income of a bond ladder is not about today’s yields, but rather about developing disciplined reinvestment to capture tomorrow’s yields.
Academic research(1) has repeatedly validated this approach, showing that bond ladders perform comparably to a total- return managed portfolio in the long run, generally defined as twice the longest maturity of the ladder. The reason is, for the most part, simple: For an individual with a 20-year time horizon, the initial yields when starting a one-to-10-year bond ladder only represent about half of the total income generation. For an example, consider the below ladder, assuming reinvestment of each bond when it matures. After five years of reinvestment, even in a scenario of slightly higher interest rates over time, income generation from the portfolio would have hypothetically risen 34%. Hypothetically, were that trend to continue, income generation after 10 years would be higher by 64% and will have more than doubled from the starting point after 20 years—even assuming our yielder add-on portfolio remained stagnant (unlikely).
While nothing in financial markets—especially interest rates— ever moves in a straight line over decades, this hypothetical scenario underscores the value of creating discipline in a bond ladder for investors with long time horizons. The key here is not the starting point, which involves historically low yields for most categories of bonds, but rather the probability that interest rates will gradually rise over time, permitting reinvestment and progressive income growth in the coming years, particularly for investors with long time horizons.
(1) For one example, see Financial Analysts Journal (Leibowitz, Bova, and Kogelman, 2015)
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