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Bond Ladders vs. Bond Funds/ETFs

Fifteen years ago when, when someone asked me if they should invest in a bond fund or create a bond ladder, I always told them that a ladder was preferable, assuming you had enough money to properly build one.

After seeing what happens to ladders in real life over time, my thinking has evolved.  In many circumstances I believe a well chosen bond fund or better yet, a mix of Bond Exchange Traded Funds (ETFs) would be a preferable choice.

This is not say that bond ladders are “bad,” just that it is “okay” to use a bond fund/ETF.

Generally investors like the ladder, because it provides “certainty” in income and the return of principal at maturity.   An investor can walk out his or her broker’s office with a nice presentation and chart that tells them exactly what income this ladder will provide in various years, and when the individual bonds will come due.

They take comfort in knowing that if interest rates go up, (and the market value of their bonds goes down), they will receive 100% of their principal upon maturity (this is assuming no credit risk).  With a bond fund there may be no telling what the market value of the bonds is in any given year as there is no set maturity date.

In real life however, these certainties have a nasty habit of evaporating.

If callable bonds are used in the construction of a ladder, there is no income certainty as many of the bonds will be called away if interest rates go down.  The bonds that are called away must then be replaced in a lower interest rate environment with a lower income or yield.  One can avoid this problem by using non-callable bonds, but such bonds generally provide a lower interest rate than the callable alternative.  In addition there is no guarantee of yield or income when maturing non-callable bonds are re-invested.

The bigger draw to the bond ladder however is that investors know that they can avoid the problem of a decreasing market value of their bonds in a rising interest rate environment (when interest rates go up, bond values go down).    If they hold the individual bonds to maturity, they will not have to sell when the market values are lower.

Once again reality often trumps the original plan.  The individual bonds have a set maturity date, but the ladder as a whole does not.  In fact the ladder is actually more like an escalator, in which the steps keep recycling themselves.

In real life at some point, all or big piece of the bond ladder will be liquidated.  This might be a result of health, estate distribution, or any host of reasons including the desire to change asset allocations.  The reality is that though it may be ten or fifteen years after a ladder was set up, there is more often than not, a time when it is liquidated.  At that point it is subject to the same market value risk as a bond fund or ETF.   Worse still, individual bonds that are sold at the retail level will not get nearly the “institutional” pricing of bonds being sold in a mutual fund.

Many investors prefer the ladder concept due to “indexing” type features.  That is, with a ladder you are not trying to bet on the direction of interest rates, you just take what the market is giving at any given time.  In this day and age it is even possible to take the best of both strategies. There are a number of ETFs (as well as mutual funds) that utilize a laddering approach within their structure.

Again this is not to dump on bond ladders or suggest one should go out and blow up their ladder and put the proceeds in a bond fund or ETF.

However if you are in a position of putting “new” money to work and are considering how to invest the fixed income portion, just don’t be so quick to write off the fund/ETF choice, particularly if you think you will be making regular adjustments to your overall asset allocation.

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DISCLAIMER: Nothing in this article should  be construed as a personal recommendation or advice.  Nor should anything in this article be construed as an offer, or a solicitation of an offer, to sell or buy any investment security.  Barnhart Investment Advisory clients and principals may hold positions in any securities mentioned in this article. Investors should conduct their own due diligence and seek the advice of a financial and/or investment  professional before making any investment decisions.


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