The macro picture these days certainly is a mixed bag. Global growth may be sputtering. Inflation may be under control, but for how long? High market volatility seems to be the new normal, while the low-interest rate environment has investors starving for income.
With this kind of uncertainty hanging over the market, nobody wants to make the wrong call, and it's all too easy to sit on the sidelines and wait it out — bracing for a rise in interest rates and side-stepping persistent volatility. But bond laddering may offer a path forward, keeping clients invested and poised to take advantage of market changes and opportunities.
Traditionally, a laddered portfolio has consisted of individual bonds with varying terms to maturity: as shorter-dated bonds mature, proceeds are invested in longer-dated maturities. Investing across a range of maturities allows investors to remain in the market — without getting locked into making a call on the yield curve. There is no need to make a call on when to sell or redeem, because it happens automatically in conjunction with the maturity of each bond in the portfolio.
Data for annual returns going all the way back to 1900 show that simple bond ladders focused on maturities of 10 years or less delivered consistent positive performance. (see chart)
The benefits and challenges of laddering
Laddering is often used as an inflation protection strategy, but it can also meet a wide variety of income and lifestyle needs (e.g., funding college tuition at specific due dates or reaching a certain retirement date). It also enables investors to create a customized duration strategy and adapt it to their changing needs.
In addition, laddering gives investors the potential to benefit from “rolling down the yield curve” and taking advantage of both income and price changes. This is a preferred strategy when the yield curve is upward sloping or steep. An investor purchases a bond at the top of the steepest part of the yield curve and holds the bond long enough until it reaches a lower yielding part of the curve. The objective is to benefit from built-in appreciation that occurs as a normally higher interest rate bond becomes a valuable shorter-term bond.
But laddering is not without challenges. The availability of individual bonds with the investor's target maturities can be lacking. There may liquidity constraints and limited trading flexibility with individual bonds; there is also the issue of concentrated exposure. Finally, cost can be an issue as individual bonds may have high minimum purchases of $10,000 or more.
Target maturity ETFs provide efficient alternative
Unlike standard ETFs, target-maturity fixed-income ETFs have a specific termination date. They pay income during their target term and then return the NAV to shareholders upon maturity. Each ETF holds approximately 50-100 bonds and is designed to track an index that corresponds to a target held-to-maturity portfolio.
Compared to individual bonds, these new vehicles can provide an efficient alternative for building laddered portfolios. They offer investment characteristics, and a predictable cash-flow profile, similar to bonds with all the advantages inherent in an ETF: cost-efficiency, liquidity, transparency, and diversification.
ETFs can be more tax-efficient than short-, intermediate- and long-term fixed income mutual funds, which can create tax liability through turnover. In addition, actively managed mutual funds and closed end funds may not maintain consistency in duration over the life of the investment—so they may not always provide specific duration and other characteristics investors need in their portfolios.
For advisers, these vehicles offer an efficient way to gain highly targeted fixed income exposure for potentially lower cost, and they are more easily implemented, eliminating the need for the investors to perform credit research. For those using model portfolios, ETFs can be easily fit into an asset allocation model to accommodate a specific timeline or risk-reward posture.
Looking for opportunity, coping with uncertainty
Target-maturity fixed income ETFs allow investors to build customized portfolios tailored to specific maturity profiles. As such they offer a way to participate in fixed income markets while also potentially reducing interest rate risk. And we believe that there is opportunity to be had in fixed income in the near and long term.
For example, there have been very high inflows into high yield this year, as investors try to meet income needs not being met by other fixed income market sectors. And from an asset allocation perspective, sustained periods of low nominal interest rates coupled with improving corporate fundamentals increase the attractiveness of higher-yielding fixed income securities. Having high-yield ETFs available in target maturities enables investors to participate in this sector of the market in an efficient, diversified, risk-managed way.
ETFs fill a gap in an investor's toolkit for a range of applications—from replacing gaps created by maturities or called bonds to managing cashflow needs, to customizing a portfolio's duration profile. But in today's uncertain market, target maturity ETFs' most compelling application may be laddering, as ETFs offer new choices to financial advisors and their clients.
Laddering with target maturity ETFs provides a level of efficiency, cost effectiveness and flexibility that was largely unavailable through wrappers and individual bonds.
Anthony Davidow CIMA®, Guggenheim Investments Managing Director, Portfolio Strategist, Head of ETF Knowledge Center.
