Why Bond Laddering ETFs Works

In a rising-rate environment, building a bond ladder could be the way to manage income, an RIA tells us.

Bond laddering with ETFs is still a relatively novel concept in the ETF space that is slowly but surely getting traction with investors who are looking for ways to manage duration risk in a rising-rate environment.

Guggenheim and iShares have extensive lineups of target-date bond ETFs today that allow for customized ladders in both the investment-grade and high-yield spaces. We’re talking about funds such as the Guggenheim BulletShares 2017 Corporate Bond ETF (BSCH | B-52), the Guggenheim BulletShares 2017 High Yield Corporate Bond (BSJG | B-66) and the iShares family of iBonds ETFs—like the iShares iBonds Mar 2020 Corporate ETF (IBDC | C-72).

Invesco PowerShares, too, has an interesting take on the theme, with the PowerShares LadderRite 0-5 Year Corporate Bond ETF (LDRI | C). LDRI is an equally weighted short-term investment-grade corporate bond index, resulting in a bond ladderlike portfolio.

As the Federal Reserve hints of an upcoming interest rate hike, these bondlike funds are useful tools for investors looking for predictability of income, said Matt Forester, chief investment officer at Newtown Square, Pennsylvania-based NewSquare Capital. Forester tells us why he likes bond ladders and how he is using them.

ETF.com: Where do you see opportunities, or concerns, in fixed income right now? Give me your big picture.

Matt Forester: There has been a lot of concern in credit and high-yield credit lately. We've been reducing exposure to credit risk in the portfolios we manage for the better part of the last year and a half or so. I think it's just a spread trade. You’re just not getting paid a whole lot to own some of that paper.

Obviously, the spreads have really widened in all kinds of areas of the market due to the energy price collapse and concerns about global markets. There’s also a cyclicality to these markets that’s impacting junk bonds.

But in a broader sense, finding opportunities in fixed income and managing fixed-income positions has become a lot more difficult for a lot of retail players and smaller advisors, especially since the financial crisis made trading big pieces of the market a lot harder. To me, it’s newer types of ETFs—I’m thinking about BulletShares and ladder-type funds—that offer a great opportunity for investors and advisors to manage their fixed-income positions.

ETF.com: In the context that the Fed has suggested it will raise rates before the end of the year, are investors better off owning perpetual bond funds or a laddered bond strategy?

Forester: The ETF ladder concept has real advantages. Now, let me first admit to a lot of skepticism about the Fed's ability to raise rates here. Clearly, that's what's going through the markets right now, but I don’t believe it will happen. Keep in mind that the Japanese central bank took its policy rate down below 50 basis points 20 years ago, and have not been able to raise it since. It’s still not able to get out of this very-low-interest-rate environment.

The Fed wants to raise rates; it would love to normalize policy. But we'll see whether they're actually able to do that.

That said, these ladder bond funds are a better way to manage your portfolios if you're wrong about the rates rising to some degree. We customize ladders, actively managing duration and yield maturities across the ladders, managing the exposure to risk.

ETF.com: The idea here is that, by laddering, you can have more control over your duration exposure as opposed to that of a perpetual bond ETF?

Forester: Exactly. I don't think most people understand how the general bond ETFs function, in that they have a target maturity and duration zone, but as time moves on, that keeps moving ahead, because the index itself has to keep adding on longer-duration issues to maintain the duration of the fund within their target.

Whatever the index is, they have to maintain that to the index, whereas the BulletShares or the ladder funds are able to ride down the curve.

And in an environment where the yield curve is still relatively steep—it's certainly flattened a lot over the last few months as we've been concerned about economic growth issues—it’s beneficial to ride down the curve to capture total returns.

ETF.com: How do you go about building bond ladders? How do you decide whether a three-year ladder or a five-year ladder is better? At what point do you want to be getting out and reinvesting at a higher rate?

Forester: We build customized ladders, and we’ve built some customized ladders for individual clients where the duration of their liabilities is known. So, it really depends on the client. We try to match the income needs to the fixed-income strategy. These ETFs—BulletShares and iBonds—are better tools than practically anything else we have in the ETF landscape to do that.

In other words, if you know you've got to pay a bill in 2020 or 2024, we can try to match the liabilities with the assets that we have inside of the fixed-income ladder.

ETF.com: If bond ladders are ideal for investors looking for predictable income, why aren’t they more popular?

Forester: I think the traditional bond ladder came about as a marriage between the investment banking side and the sales side of a lot of wire house funds. When you think about it, they were creating new issuance on the investment banking side, and a bond ladder was an easy concept to sell to a retail investor. It was a way of generating a steady stream of new demand for the bonds that they were creating from the investment banking side.

So I think, in a lot of ways, the traditional bond ladder was a device that worked really well for the sellers of the bonds and maybe not as well for the individual investor. But ETFs changed that. You can now manage these for income if you want. You just have to consider how far you want to go out on the duration spectrum.

In today's environment, where everyone is concerned almost exclusively with the prospect of higher rates, an ETF bond ladder gives you better control over that duration.

Like everybody else, the issuers themselves have been a little surprised that these ETFs have not been as warmly received as maybe I would have expected.

At first, I thought the investor base was simply testing out how the initial funds were going to mature. They wanted to see how the wind-down process was going to work. But that's clearly been in the rearview mirror now, with virtually no problems. Since the concept seems to be proven and seems to be working, I'm surprised we haven't had more investor demand for it.

I think it's partially because there aren’t a lot of advisors who are targeting duration too much; they’re not building portfolios that way. But as the rising-rates theme continues to play itself out, it will highlight the attractiveness of the bond ladder and ETFs as we go forward.

ETF.com: Do you think some of these online tools, like the BulletShares laddering tool that they launched earlier this year, have an impact on investor adoption? Do you use tools like that?

Forester: Sure. They're great. I really applaud the efforts from the sponsors to start to measure effective duration across portfolios. There's a movement to try to get these baskets of bonds inside our portfolios and make sure that we, the investor—and particularly more sophisticated retail investment advisors—have the ability to look into that and see exactly what the characteristics of the underlying bonds are.

There are movements across different technology platforms to try to share a lot of that information so that investors are able to see that more clearly. But yes, I use these tools. Clearly, whenever you're dealing with technical issues around bond funds, there's some sophistication that's needed to evaluate exactly what you're trying to achieve. These tools help show that.

ETF.com: From your perspective, are there any risks to opting for a bond ladder or any challenges with managing downside? How do bond ladders fall short relative to other types of bond ETFs?

Forester: The only place where I have a little concern is on the very short end of the ladder. I wonder whether the very short ladder pieces are as efficient as some of the short-term ETFs out there, or a money market fund, or cash assets in a portfolio. You're still paying an expense ratio on a fund that is effectively holding cash by the time these things mature.

But ETF bond ladders offer tremendous diversification inside of the maturity window you're looking at. For me, it's still a comparison against individual bond ladders, where, if you're thinking of credit risk inside a diversified fund, think about how much risk you have if you were just to own a slice of one bond inside of your bond ladder. If you held a 10-year ladder and you have 10 bonds in there, a default on one of those bonds would leave a tremendous hole in your portfolio. That’s not the case when you’re laddering ETFs.

Contact Cinthia Murphy at [email protected].