Bond Ladders vs. Bond Funds: Which Are Best for Portfolios?

Bonds are a popular investment offering the prospect of a steady income stream. Bonds are generally less volatile than stocks and can help diversify client portfolios. Bonds have been a bit more volatile amid high inflation and rising interest rates.

Two of the most popular ways to add bonds to a portfolio are through the use of bond funds or by building a ladder of individual bonds. Both offer opportunities for advisors and their clients to build the fixed income allocation in their portfolios.

What Is a Bond Ladder?

A bond ladder is a series of individual bonds that mature over time. The maturities are typically staggered at regular intervals; for example bonds in the ladder might mature over a period of five to 10 years.

The investors earn the interest paid by the bonds in the ladder while they are held, and they have options as to how to reinvest or use the money as each bond matures. In some cases, this might entail buying another bond at the long end of the ladder. In other cases, they might invest the money elsewhere or use it for another purpose.

A bond ladder might look like this:

The total amount of annual interest payments on the bond ladder is $4,150. As each bond matures, the investor will receive the par value, which they can choose to reinvest in another bond at the far end of the ladder or use in another way.

Benefits of Bond Ladders

• Stability and predictable returns: “As long as you hold the bonds to maturity and the issuer doesn’t default, you know exactly what your return will be,” says Taylor Schulte, a certified financial planner, founder and CEO of Define Financial. Bonds held in a bond ladder should generally be noncallable and have fixed interest rates to help ensure this stability.
• Minimizes interest rate risk: “Many advisors see bond ladders as a way to lock in the current rates by holding the bonds to maturity,” says Mike Sanders, portfolio manager and head of fixed income at Madison Investments. This minimizes the risk of incurring capital losses that could occur if bonds were sold in a rising interest rate environment prior to maturity.

Drawbacks of Bond Ladders

• Trading costs: Many individual investors will not have the money to allocate to bonds that would allow them to get the best pricing on bond transactions. Acquiring the number of bonds needed to build an effective bond ladder may be cost-prohibitive for some investors.
• Lack of bond expertise: Most individual investors and many financial advisors may not have the capability to research the quality of numerous bond issues as well as the characteristics of bonds they might consider in building a solid bond ladder.

In constructing a bond ladder, it is generally suggested that you use noncallable, high-quality bonds to minimize the risk that the bond issuer will be unable to continue to make their semi-annual interest payments. This way, your client will have a bond maturing at regular intervals and a stream of income that they can depend on.

What Are Bond Funds?

Bond funds are professionally managed mutual funds or ETFs that invest in bonds. Bond funds can be actively managed; the managers buy and sell bonds to construct a portfolio of bonds that meets the fund’s objectives. Bond funds can also be passively managed and track a bond market index.

Bond funds may be short, intermediate or long in their overall duration. They may focus on certain types of bonds, such as corporate bonds, Treasurys, municipal bonds, foreign bonds or other types.

Owning several bond mutual funds and ETFs as part of bond allocation in a client’s portfolio can help them build diversification into their bond allocation.

Benefits of Bond Funds

• Professional management: In the case of actively managed bond funds, Sanders cites the ability of the fund manager to take advantage of the opportunities the bond market is offering at any time. “This could entail positioning all or part of the fund portfolio in terms of credit quality, focusing on bonds in one or more market sectors and going longer or shorter in terms of overall duration as market conditions dictate,” he says.
• Better pricing: Schulte points out that it is far more likely that a fund that buys bonds in lot sizes that can exceed $1 billion is going to get much better pricing on their trades than an individual investor or an advisor buying $50,000 worth of a bond. This pricing advantage can translate into lower overall costs for many bond funds.
• Low barriers to entry: Many bond funds have low or no minimum investments. Investors can start small and build their holdings in one or more bond funds over time. Individual bonds may require an investment of $10,000 per bond.
• May provide greater liquidity: Some types of individual bonds may not have liquid markets for buying and selling. Investing through a bond mutual fund or ETF can reduce this lack of liquidity and the resulting price hit investors can take when selling illiquid bonds.

Drawbacks of Bond Funds

• Bond funds never mature: During a period of rising interest rates, investors may be faced with losses if they need to sell quickly, especially in funds at the longer end of the duration spectrum.
• Less control over distributions: Schulte points out that you have less control over capital gains and interest distributions when investing in bond funds in a taxable account as compared with holding individual bonds. This makes your potential tax liability less predictable.
• Expense ratios: Many bond funds and ETFs have relatively low fees and expense ratios, but others do not. Advisors and investors need to take this factor into account, along with the type of bond fund, the manager’s record and other factors when deciding whether to add a particular bond fund to their portfolio.

Bond mutual funds and ETFs can be a solid way for your clients to allocate assets to bonds within their portfolio. Professional management and the availability of bond funds with various objectives make this a sound option.

Which Is Better?

Both bond funds and bond ladders offer advantages for investors in building the bond allocation in their portfolios.

Bond ladders offer a degree of stability and certainty if properly constructed with high-quality, noncallable bonds. However, if advisors or individual investors are not comfortable selecting individual bonds or cannot buy them at competitive prices, then this might not be the way to go.

Bond mutual funds and ETFs can be an excellent way for advisors to spread their client’s bond allocation across several funds that make sense. These can vary by duration, type of bond, active or index, and other features.

Bond Ladders and Bond Funds Are Not Mutually Exclusive

Depending upon your client’s situation and the size of their portfolio, there is nothing that says that you cannot use both bond funds and a bond ladder to allocate assets for the fixed income portion of their portfolio.

The portion allocated to a bond ladder would provide steady cash flow on a regular basis from the interest from the bonds, with the opportunity to reinvest or reallocate the money from maturing bonds at regular intervals.

(Image: Chris Nicholls/ALM)