Why Laddering Bond ETFs Works Right Now

October 02, 2014

ETF.com: This approach seems to involve constant maintenance. Why not just make peace with a perpetual bond fund? What's the shortcoming with owning something like the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD | A-68)?

Schmidt: The problem with LQD, or mutual funds in general, is that you're managing against an index. And you're trying to beat that index, but the duration of your fund never shrinks. You never get to the end game, you're always selling and rebuying, and you're setting yourself up for more principal fluctuation over time when you don’t have that end game in mind.

Let’s say I was in an aggregate bond market fund like the Vanguard Total Bond Market ETF (BND | A-93), I'd still own the duration of the aggregate bond market, and I will not have moved down the yield curve. I will not have gotten a chance to get my principal back, and maybe reinvest it at a higher rate.

Laddering is a good structure for those cash flow needs I talked about, and it’s also a good structure for someone who believes interest rates are going to be on the rise and they want that opportunity to reinvest. It’s the investors making the reinvestment decision, not the portfolio manager.

ETF.com: In your experience, does laddering work for every type of investor?

Schmidt: Yes, it can work for anyone. But I see it used more by people who are getting close to retirement, and are maybe trying to bridge a period of time between when they retire, say, at age 62 and when they begin getting social security or pension at 65. It’s filling a gap in funding needs. A bond ladder’s a great way to fund that gap with some certainty.

ETF.com: Is there any major challenge to implementing an effective ladder?

Schmidt: The ETF world has made it easy. With that said, there are still some nuances having to do with reinvestment of capital that I, as a portfolio manager, am paying attention to. If someone’s doing it themselves they need to pay attention to those nuances too.

In the Guggenheim structure, if you have a 2015 maturity, those bonds start maturing in January 2015. Let's say 1/12th of the portfolio matures in January, then February, then March. What Guggenheim is doing is taking those proceeds from those higher-yielding bonds and reinvesting it in Treasurys. So, you'll get all your money back at the end of the year, but that last year you start to lose yield as those higher-yielding bonds mature and are placed in a safer asset: Treasurys.

What we do to manage portfolios is we look early in the year and try to make a determination of whether we want to take that 2015 maturity, turn it into cash, sell it or roll out to the end of the ladder to pick up additional yield. People need to be aware that as the year goes on, you start to lose yield in that particular holding for that particular year.

 

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