Swedroe: Bond Ladders Unfairly Demonized

July 11, 2016

I often hear criticisms from the financial media and some professional advisors about the use of bond ladders. Whenever the criticism comes from professional advisors, however, I’ve noticed it generally involves firms that use only bond mutual funds or ETFs instead of individual, tailored bond portfolios, whether in the form of a bond ladder or not. Unfortunately, much—if not all—of this criticism is based on falsehoods and the conflicts that can arise when advisors employ only mutual funds and ETFs.

An investor recently brought to my attention a piece that restated many of the old canards about bond ladders. But this article is just one of many. Even highly regarded finance columnists have taken laddered bond portfolios to task. To correct the misperceptions, we’ll address each of the criticisms typically raised, beginning with credit risk.

1. Credit Risk and the Need for Diversification

It’s true that one of the greatest benefits of mutual funds is diversification, which is critical for investments that contain a lot of idiosyncratic risk, like stocks and junk bonds. However, with Treasury bonds and FDIC-insured CDs, there’s no need to diversify, because there isn’t any credit risk.

With corporate bonds, because of the risk of default, there is a need to diversify. Thus, for these assets, mutual funds should be the preferred choice. However, with municipal bonds, if one limits their holdings to AAA/AA and only general obligation (GO) and essential service revenue bonds (the bond types recommended in my book, “The Only Guide to a Winning Bond Strategy You’ll Ever Need”), the need for diversification is greatly reduced because there is little credit risk (almost all of the risk in these bonds is term risk).

For example, since 1970, losses from default on bonds of these types have been virtually zero, and that includes a period spanning several recessions and the latest severe financial crisis.

In fact, credit quality will be higher (likely significantly higher) through a ladder of individual AAA/AA general obligation or essential service revenue bonds than it will with almost any municipal bond fund, and certainly higher than with popular Vanguard funds.

For example, Vanguard’s Intermediate-Term Tax-Exempt Fund (VWITX) has about 25% of its portfolio invested in credit rated below AA. And about 5% of the bonds held in the fund are either below A or unrated. So, even though VWITX does have a more diversified portfolio than an individual investor holding a bond ladder would, the holdings are also clearly riskier, requiring that greater diversification. That’s one canard down.

2. High Cost of Implementation and Maintenance           

The argument that laddered bond portfolios have high implementation and/or maintenance costs goes something like this: “Individual investors who trade bonds pay very high costs compared with institutional investors.” However, there are a few problems with this assertion.

First, one can buy Treasury bonds at issuance directly from the U.S. Treasury at the very same prices institutional investors obtain. What’s more, there are online services where you can check prices, which are highly transparent. Second, with FDIC-insured CDs, not only are there little to no trading costs, yields can be much higher than they are on Treasurys.

For example, as I write this, the yield on five-year Treasurys is just 0.99%. At the time, five-year CDs were available yielding 1.65%. That’s a difference of 0.66 percentage points, even before taking into account mutual fund expenses. If you own a bond fund, you then have to subtract its expense ratio, making your return even less. In addition, mutual funds cannot buy CDs. This is a huge disadvantage for investors when they limit their investments to mutual funds.

 

Find your next ETF

Reset All