Why Laddering Bond ETFs Works Right Now

October 02, 2014

Forget perpetual bond ETFs—a laddered strategy might be just what you need in this rising-rate environment, Gradient Investments’ Wayne Schmidt says.

If interest rates do rise in the next year or two, laddering a bond portfolio could prove to be an effective way of managing duration risk while collecting a somewhat-predictable income. That’s in essence what Wayne Schmidt, chief investment officer of Arden Hills, Minnesota-based Gradient Investments suggests.

In his view, a laddered bond portfolio helps investors fill income gaps, and meet cash needs in a way that perpetual bond funds don’t allow. His firm—a third-party money manager that manages some $640 million in assets today—has turned laddering with Guggenheim’s BulletShares suite of target-date bond ETFs into a centerpiece of its approach to fixed income.

Schmidt tells ETF.com why laddering works, how to go about it and what risks you need to fully understand before jumping in.

ETF.com: BulletShares ETFs now cover eight years of high-yield and 10 years of investment-grade exposure in the corporate bond space. That’s basically access to the full spectrum of the curve in corporate bonds. Is that the right way to look at the BulletShares suite?

Wayne Schmidt: That would be a fair way to look at it. The way we use it is we're building three-, four- and five-year ladders, so we haven’t gone out that far. But it’s nice to have product if somebody wants that.

Our investors are primarily going into a three-year ladder—that’s the most popular—because they are of the belief that interest rates are going to rise. In the three-year ladder, you're getting money back to reinvest at higher rates a year or so from now.

ETF.com: These portfolios essentially work like a single bond would. What's the breadth of what you can do with these types of ETFs?

Schmidt: I was an institutional fixed-income manager, so I worked with individual bonds all the time before. But what I find is the retail investor doesn't have enough assets, enough quantity of wealth to diversify properly. What's great about the Guggenheim ETFs, and ETFs in general is that individual investors can get the diversification that they need.

Within one of those ETFs, let’s say the 2015 high-yield Guggenheim fund [Guggenheim BulletShares 2015 High Yield Corporate Bond ETF (BSJF | B-68)], they’ll own 250 different individual bonds in that portfolio. When you're talking credit risk, it’s great to have numbers. And to have 250 issuers in one ticker, that’s beneficial to the individual investor.

ETF.com: Why ladder a bond portfolio?

Schmidt: A lot of individual investors have different needs for cash, and the one nice thing about laddering is that it has a maturity. In the past, you could only do that with individual bonds.

Say you're a parent or grandparent, and you want to save for a child’s or a grandchild’s college. You know you have this liability that's going to be paid out in a four-year period, but you don't want to risk a lot of your principal, so a four-year ladder is a great example of how you can structure it so that you get your funds back over that four-year period.

We've had clients come in where they’re taking care of a parent who now needs assisted living. All of a sudden, they had an investment portfolio but now they needed to get cash on a regular basis to pay for the assisted living. It’s nice knowing that you know when that cash flow is going to come back to you with some sort of certainty. Yes, there’s default risk and things like that, but you at least know the date.

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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.

 

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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High-Yield BulletShares ETFs

 

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