From the September 2002 issue of Investment Advisor • Subscribe!

Climbing the Ladder

Mutual funds that stagger their bond maturities ca

Many investors are scrambling to the perceived safety of fixed income in these troubled market times, but bonds have risks of their own. There is the chance that an issuer will go broke, of course, as well as the possibility that bond prices will fluctuate widely as interest rates rise and fall. And don't forget reinvestment risk--the problem investors face when their bonds mature while rates are on their way down.

One way for an advisor to work around these problems is to invest in a "laddered" portfolio containing bonds with staggered maturities. The diversification of such a portfolio helps mitigate credit risks, while the staggered maturities help avoid reinvestment shocks and offer a value-added solution whether rates go up, down, or sideways. Indeed, a bond ladder preserves flexibility while smoothing the volatility of the income stream, since at any given time the current yield of the portfolio is the average of all the bonds in the portfolio. This includes bonds purchased in periods of high or low rates.

Here's the challenge: Not all bonds and bond funds are the same. Investors and their advisors are consistently lured by high yields into high-risk bond strategies, only to lose principal. Remember the stock market crash in 1987? More money was lost in bonds that year than in stocks.

Why? As interest rates fluctuate, the present value of a bond's stream of interest payments constantly changes. And the longer the stream of interest payments, the higher the price volatility. The market value of a bond goes down when interest rates rise, because its interest rate is fixed and cannot compete with newly issued bonds paying higher rates.

In terms of variability of total return, long-term bonds look more like stocks than short-term, fixed-income vehicles. Eugene Fama studied the rates of returns of long-term bonds from 1962 to 2001, showing that these bonds historically have had wide variances in their rates of total return, without sufficiently compensating investors with higher expected returns.

The data indicate long-term U.S. treasuries have both lower average returns and higher price volatility than intermediate-term Treasuries. Investors have not been compensated for the higher risk of long-term bonds. In our opinion, the higher nominal yield of long-term bond funds is not enough to compensate the investor for their highly volatile NAVs.

Aside from the issue of volatility, bond investments also have other risks, such as a compromise between reinvestment risk (the risk that your income stream may change) and market price risk (the risk that the price of the bond may change if prevailing interest rates, inflation, or other factors cause bond prices to start fluctuating).

You Never Know

Let's say a client walks into your office one day this month with $1 million and wants to invest in a five-year bond. He tells you he wants to know what the value of that investment will be on a specific date five years in the future. My question to him would be, "Why do you need $1 million that day?" You say that date could turn out to be a terrible time to reinvest $1 million. Or it could be a great day to reinvest. You never know: Rates could be at 10%; but they also could be 2%.

Here is an opportunity for you to explain the concept of bond laddering and why your client might be better off investing $100,000 in 10 different bonds that mature consecutively each Sept. 25 for the next 10 years, thus spreading out his reinvestment risk. Next, explain that there are other ways of eliminating the reinvestment risk, such as buying very-long-maturity, zero-coupon bonds--but there would still be market price risk.

Consider how a "normal" yield curve facilitates this situation (See chart 1, page 73).

Notice that somewhere between 8 and 12 years, available yields level off. The more market price risk you take beyond that time, the less incremental return you receive for increasing your price risk. Quite frankly, you usually don't get any noticeable incremental return for locking in your yield for a longer period of time than 12 years.

Unless your client believes we're going into a long deflationary period (be sure to ask him), why take that risk? Many investors seek to eliminate market risk by investing for a shorter term in a money market fund. What they don't think about is they are taking on a high level of reinvestment risk.

Risky Money Funds?

Most investors have never considered that they are taking any risk in a money market fund, but chart 2 (top right) provides a clear example of the reinvestment risk associated with a $100,000 investment in the average money market fund during periods of falling interest rates.

Look at the drop in earnings from 2000 and 2002. That's a vivid example of reinvestment risk. An investor is subject to this risk both when interest income is received and when invested principal matures.

Many advisors focus only on the possibility that the principal value of a 5- or 7-year bond could fluctuate--which it can. At some point it becomes apparent to you and to your clients that accepting a couple of points of price risk is no different than accepting several points of income risk.

Investors who are unhappy about this yield erosion often compound the damage by going from one extreme position to another (a very long maturity bond investment, or a gimmick fund) at exactly the wrong time. Check out chart 3 (below, right), which shows 30-year U.S. Treasury bonds and their relationship to bond mutual fund sales. Because yields and bond prices are inversely correlated, bond prices are high when yields are low. You would expect people to buy fewer bond funds when bond prices are high, but that's not what the mutual fund sales figures show. In fact, investors do the opposite in an attempt to time the market. It's almost exactly wrong in a very predictable way. You can see that in almost every peak and trough of interest rates in the last 18 years--including the current one--investors did the exact wrong thing. It's no wonder that some investors hate bonds. They don't have a sensible bond investment strategy.

And typically, all the attention of bond market commentators is focused on long-term bond yields. Intermediate maturity bonds are overlooked. But these bonds not only provide very good, long-term average returns, they do it with half the volatility of long-term bonds.

What do you say if your investors want to buy only an individual bond, versus investing in a bond fund? One big issue is that with an individual bond there's no guarantee that you'll be getting it at the best price. You're competing with the greater buying power of bond dealers, mutual funds, and other institutional investors. What's more, the price an individual buyer may be quoted on some bonds can vary widely from dealer to dealer.

To be sure, advisors can put together a bond ladder for an individual client using 15 to 20 bonds. At best, the portfolio will have perhaps two maturities per year. So, investors are exposing themselves to a fair amount of risk, not so much in terms of market prices, but in reinvestment. You're basically called upon to guess interest rates for the remainder of the year. Is that a good time to reinvest the money, or should you stay in cash, or should you go extra long?

Laddered Funds

By contrast, a laddered bond mutual fund will ideally have many more maturity dates on that ladder. Not just one or two bonds are maturing in a given year; the number is more like 20 or 30. Because a bond mutual fund is in the market all the time, reinvestment risk is thus smoothed out (chart 4, right). This is one bond investment strategy that both appeals to common sense and has delivered good results over time. Laddering tends to outperform other bond strategies because it simultaneously accomplishes three bond investor goals: Producing attractive income for the price risk incurred; capturing price appreciation as bonds age and move down the yield curve; and spreading reinvestment risk. Essentially, you are hedging your bets. If rates go up, you always have some money coming due for reinvestment; if rates go down, you don't have it all coming due at once, thereby preserving your higher yields (and price appreciation) in the rest of the portfolio.

Three Scenarios

Consider three interest rate scenarios where income streams are mechanically reinvested in a very simple laddered bond portfolio over a period of 10 years (chart 5, bottom right). The center line represents no change in interest rates, providing a steady return each year in the laddered portfolio. That return often happens to be fairly close to the return of the longest maturity bond in the portfolio. But your duration is shorter at the onset, and your reinvestment risk is spread out in an intelligent manner.

If interest rates rise immediately after you assemble the laddered portfolio (follow the bottom line), bond values initially drop, but only temporarily. Time passes, and the ladder has maturing bonds each year. This gives the portfolio a stream of cash flow to reinvest in new, cheaper, higher-yielding bonds, even if interest rates remain at the new higher levels. Even the bonds that don't mature will move down the new, higher-yield curve, which helps them recover value prior to actual maturity dates.

Don't Be Depressed

The laddered portfolio creates a consistent pattern of investment, much as dollar cost averaging does for an equity portfolio. Without maturing bonds, the fund manager would be forced to sell bonds at depressed prices as a way of generating cash for reinvestment.

As proceeds from maturing bonds are reinvested in higher-yielding bonds toward the back end of the ladder, the portfolio's yield gradually increases. Before long, the average annual total return begins to exceed that of the same starting portfolio if interest rates have not increased.

Suppose you invest and interest rates fall (the top line)? Initially, the bond portfolio's return rises in value as bond prices get marked up. Ultimately, as those bonds mature and proceeds are reinvested in lower-yielding bonds, the portfolio's long-term return is lower than it would have been under the first two scenarios. The income stream also decreases, but only gradually because the longer-term higher yielding bonds continue to be held in the portfolio, and the income generated continues to be the average of all the bonds.

If your client is open to a sensible investment course no matter which way interest rates move, any time is a good time to build or invest in a laddered bond fund. With a laddering strategy, it's possible to get attractive returns. It's the smart way to increase the portfolio's return while minimizing both market risk and reinvestment risk.

Brian McMahon is president and chief investment officer of Thornburg Investment Management in Santa Fe, New Mexico. For a more detailed report on laddered bonds, e-mail the author at info@thornburg.com.

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