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
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
Not a good hedge against inflation
May not be very liquid (without significant
discounts in price of bonds being sold)
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
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:
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
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
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
– 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.
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