Why Laddering Bond ETFs Works Right Now

October 02, 2014

ETF.com: Are you laddering both in high yield and investment grade, or are you staying away from one of the segments?

Schmidt: That’s another piece of the implementation challenge. You have to make a determination on where you see value in the market.

High yield looks great because the yields are so much more attractive than investment grade. But high yield is going to be more volatile. You need to come to grips with that and decide how you are going to build that portfolio. Do you take each year and go half investment grade, half high yield? Or do some other mix?

We look at the relative value, and, say, in a three-year ladder, in years one and two, we’re going to go high yield because there's not a lot of yield today in investment grade. It doesn’t make any sense to buy the investment grade that short term. But if we started to get out to year three, four and five, the risk in high yield is a lot higher; we might want to add some investment grade to that mix.

Right now, our portfolios are probably about 88 percent high yield, 12 percent investment grade in a three-year ladder. In a different market, where high yield doesn't have such a yield advantage over investment-grade, that split would probably change. But that's a decision each investor needs to make.

Simply from a relative-value standpoint, we would own more high yield versus investment grade right now so that we can generate that additional income.

ETF.com: How do you manage the downside?

Schmidt: Investors have to understand that their principal is going to fluctuate as they move through time. It’s not a straight line. We may have a month like we had in July where credit spreads widened and high-yield tickers dropped about 1.6 percent.

We try to educate our advisors and clients on the fact that you have to live with a little bit of fluctuation. But when you buy in, you know what that yield-to-worst is, and you'll experience that. You have to stay for the whole three years to get that. But people get a little bit nervous and maybe they want out.

There's going to be some price movement in these vehicles. If investors are used to owning CDs at banks, or other safe products, they don't see that price fluctuation. There's no free lunch. You might get more yield, but for that you have to live with a little bit more price volatility.

ETF.com: When it comes to the overall fixed-income allocation in a portfolio, how much of that allocation should be a laddered strategy?

Schmidt: I’d say part of that answer depends on your view. Laddering would be a more defensive position in a bond portfolio. If you were negative on interest rates, you would probably want more of your fixed-income portfolio in a ladder.

And if you were bullish on interest rates, you think they're coming down, you would put more of your money in traditional fixed income where you get more price appreciation.

 

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