Perspective published on February 24, 2023
Taking the Measure of Bond Ladders
Breckinridge offers actively managed, investment grade (IG) fixed income strategies that strive to reach the investment and income goals of our clients. In managing client portfolios, Breckinridge seeks a diversified maturity and duration structure.
Breckinridge tax-efficient strategies focus on income generation and stress tax-efficiency throughout the portfolio management process. While these goals are similar to those of a municipal bond ladder, we view laddered strategies as unnecessarily restrictive in their approach.
A traditional ladder approach can limit security selection, proactive trading, portfolio structure and, ultimately, opportunities to build, sustain, or enhance investment returns.
Breckinridge believes a less rigid approach can pursue objectives similar to ladder strategies while providing flexibility to opportunistically take advantage of changing market conditions. We believe a strategy unencumbered by the restrictions that we believe characterize ladder strategies may be more likely to capitalize on market opportunities and manage risk exposures by offering access to more bonds, trading tactics, and portfolio structures.
In this article, we will look at some of the key limitations of municipal bond ladder strategies.
How ladders traditionally work
Typically, ladder strategies set bond maturities at 6- or 12-month intervals over 5- or 10-year periods.
Investors count on receiving interest payments from bonds across all maturity steps in the ladder. In addition, investors expect bonds to return capital at maturity.
Proceeds from maturing bonds are reinvested in new bonds added to the long end of the ladder’s maturity structure. Investors are focused on bonds with the appropriate maturity and other characteristics.
It is anticipated that this systematic and repeatable process could help investors mitigate impact of rising rates, create a diversified portfolio, and plan for potential income. However, these benefits can come with severe limitations.
Ladders may limit security selection
Selecting securities for ladders assumes that, at every maturity date, bonds with the desired characteristics will be available in the market at an appropriate price. Based on the nature of the municipal market, this assumption can prove impractical at times, such as in cases when there are state-specific or state-biased requirements, for example.
Consider the example illustrated in Figure 1. As illustrated, on any given day, there are only a certain number of bonds with a 10-year maturity on offer in the municipal market. After determining the number of bonds available in the 10-year range, characteristics such as the state of issuance, credit quality, sector, and issuer need to be considered in order to meet the criteria set forth by the ladder strategy.
The series of limitations, along with the ladder’s rigidity, particularly when investing for a state-specific or state-biased portfolio, could reduce suitable investment opportunities substantially.
Now consider the increased flexibility of a bond strategy that allows greater optionality in security selection. Rather than being restricted to adding a bond maturing in 10-years at the end of a ladder, for example, an active approach might choose to purchase a 12-year bond with a 10-year call option or two bonds with maturities bracketing the target 10-year maturity, as long as they also meet the investor’s tax-exemption, income, credit quality, sector, and other requirements.
One can logically expect that as the options available to the strategy increase, so too will the security selection choices. As more choices are available to the portfolio manager, the potential that the investor’s objective can be reached more efficiently and with great flexibility may also increase. A broader security opportunity set also holds the potential of allowing adjustments along the way to accommodate evolving investor objectives in response to changing circumstances.
Ladders may limit proactive trading
Ladders typically limit reinvestment timing to redemption dates. From time to time, selling a bond before maturity or call and reinvesting the proceeds can capture value. For example, during a period of rising rates, a bond may be sold in a tax-loss swap to provide capital for investment at a higher yield.
Over the course of a year, the municipal market may experience a lack of supply and/or an increase in demand, potentially decreasing opportunity. The converse is true as well, as the municipal market can trend toward oversold, with more bonds for sale and fewer buyers for them, potentially increasing opportunity.
As such, the flexibility to sell a bond before maturity and purchase another bond can help to build, sustain, or enhance after-tax income. Without trading the portfolio excessively, an active strategy may be able to avoid buying bonds during times when prices are higher, or capture values when prices are lower. A ladder, as a buy-and-hold strategy focused on periodic trading dictated by maturity structure, would tend not to leverage opportunities or mitigate reinvestment risk through proactive trading as market conditions change over time.
Ladder arrangements may restrain portfolio structure
In addition to limiting the number of securities available for purchase, a ladder also constrains the portfolio structure.
Because a ladder is, by definition, an equally weighted portfolio, its profile along the yield curve does not change. Ladders invariably reinvest at the long end of their maturity limit, even when that maturity may not represent the best relative value or risk-adjusted return.
In contrast, active strategies can modestly adjust yield curve exposure, targeting a more bulleted or barbelled position, based on market conditions.
Breckinridge historically has not bet on the direction of rates and has sought diversification. Rather, similar to trading more opportunistically, we believe that active structures can be utilized to effectively help build, sustain, or enhance income by making tactical adjustments to holdings characteristics in light of changing market conditions.
Questions to ask a laddered portfolio manager
Here are four additional questions to ask when considering a bond ladder strategy.
- Is the manager selecting and marking up bonds chosen for the ladder from its own existing inventory of bonds or purchasing bonds from the broader universe available in the municipal market each day?
- How is trading conducted by the manager? How broad is the network of dealers operating nationwide with whom the manager maintains relationships?
- What are the credit research capabilities of the manager of the bond ladder? Does the manager maintain its own credit research teams or relay solely or primarily on third-party research?
- How does the manager allocate bonds among its investors’ accounts? If a bond available in limited supply is considered to be an appropriate investment for multiple accounts managed by the firm, how is the decision to allocate that bond across various accounts such as ladders, actively managed accounts, mutual funds, separate accounts, or other investment accounts?
Similar to Breckinridge’s tax-efficient strategies, ladders seek a diversified structure, income generation, and tax-efficiency. Unlike Breckinridge’s approach, their structure can be considered more rigid, which can limit their ability to adjust to market opportunities or risk factors.
We believe an active investment manager can apply a disciplined approach to interest rate exposure that seeks diversity and consistency without the constraints of a ladder. While the restrictions that we believe are inherent in bond ladder strategies may suit some investor objectives, we believe they are not well suited to the municipal market’s inefficiency and erratic supply.
For Investment Professional and Institutional Use Only.
This article provides general information and should not be construed as a solicitation or offer of services or as legal, tax or investment advice. Nothing contained in this article should be considered a guide to security selection or the construction of a portfolio by an investor.
The content is current as of the time of writing or as designated within the material. All information, including the opinions and views of Breckinridge, is subject to change without notice.
All investments are subject to risks, which include the loss of principal. Diversification and asset allocation cannot guarantee a profit or protect against a loss. Active investing generally involves more risks than laddered strategies because active managers may take on greater market risk to outperform their index. There is no guarantee that either passive or active investing will achieve their performance objectives. Active strategies also tend to have higher management fees and operating costs than passive strategies. Investors should consider all the differences and risks before making any investment decisions.
Some information has been taken directly from unaffiliated third-party sources. Breckinridge believes the data provided by unaffiliated third parties to be reliable but investors should conduct their own independent verification prior to use. Some economic and market conditions contained herein have been obtained from published sources and/or prepared by third parties, and in certain cases have not been updated through the date hereof. All information contained herein is subject to revision. Any third-party websites included in the content has been provided for reference only.