Seven Reasons Why Advisors Should Use Bond Ladders

I often hear criticisms from the financial media and 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.

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An investor brought to my attention a piece that restated many of the old canards about bond ladders. This article is one of many. Even highly regarded finance columnists like Jane Quinn have taken laddered bond portfolios to task.

To correct the misperceptions, I’ll address each of the criticisms typically raised, beginning with credit risk.

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  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 these types of bonds 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 7% 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.

  1. 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, the yield on five-year Treasurys is just 1.8%. Five-year CDs are available yielding 2% or more. That’s a difference of at least 20 basis 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.

Returning to the issue of trading costs, the point about individual investors paying very high costs compared with institutional investors is generally correct if you are an individual buying municipal bonds (or corporate bonds, which I’d recommend you avoid) in the secondary market, not the primary (new-issue) market. In the primary market, all investors get the same pricing.

Because the secondary markets in municipal and corporate bonds are less transparent, individuals buying on their own through broker-dealers can pay large markups, which can range from about 1% to as much as 6%. Therefore, this practice should be avoided. Instead, individuals buying municipal bonds on their own should limit purchases to new issues, which, as mentioned, are sold to all investors at the same price.

However, a Registered Investment Advisor like my firm, which buys several billion dollars’ worth of bonds a year, is able to obtain the same type of pricing that institutional investors like Vanguard get by putting broker-dealers into competition with each other. Markups average just 0.1-0.2% in price (dealers are entitled to make some profit), which, for a bond ladder with an average maturity of five years, would be only about 0.02-0.04% in yield.

In addition, while an institutional investor wouldn’t be interested in buying a small lot (say, $25,000 or $50,000), RIAs that create bond ladders can buy such bonds, which typically have the advantage of trading at higher yields for those willing to be providers of liquidity by being patient buyers.

RIAs that use laddered bond portfolios are often able to buy smaller lots at prices often well below (not above, as the aforementioned article would lead you to believe) the prices paid for large lots. Incremental yields are frequently in the neighborhood of 0.30%, or even well above that. And of course, the investor is avoiding the cost of the mutual fund or ETF. That’s two canards down.

By Larry Swedroe, read the full article here.