Bond laddering, which involves investing equal amounts in bonds at staggered maturities, is a common investment strategy in fixed income. A passive strategy designed to track the market, bond laddering is often perceived as less risky than active bond management. However, laddered bond portfolios are subject to the same interest rate and credit risks common to all fixed income investing, and their rigid structure limits both the ability to manage those risks and opportunities to earn higher returns.

Active bond management, by contrast, can offer the potential for higher returns as well as greater flexibility to manage risk. With returns on financial assets expected to be relatively modest over the next several years, maximizing returns on a bond portfolio—and hedging a portfolio against the risks that can result in negative returns—have become more important for investors.

Uses and Limitations of the Bond Ladder

When a bond portfolio is laddered, equal amounts of bonds will mature on a regular basis, such as every year or every two years. Bond investors most commonly use laddered portfolios:

• To match cash flows or liquidity needs;
• To match a liability structure;
• To simplify portfolio implementation;
• To avoid the need for forecasting interest rates; and
• To avoid the task of monitoring credits.

Some investors assume that passive fixed-income strategies such as laddered portfolios are inherently less risky than active strategies because of their market tracking characteristics and the diversification of maturities. This is not necessarily the case; laddered portfolios with staggered maturities have several limitations and can introduce certain risks.

First, laddering may result in a loss of potential alpha. Laddered structures are passive, buy-and-hold strategies that require high credit quality and stable cash flows. Laddered portfolios therefore typically rely heavily on relatively low-yielding U.S. Treasury bonds, particularly the most liquid “on-the-run” securities, or AAA-rated insured municipals. Because Treasuries and AAA- insured municipals are the most actively traded securities, they usually command a high price for their liquidity and provide lower yields in return. In addition, municipal bonds such as essential service revenue and general obligation bonds are already highly rated credits, so adding insurance to these securities is unnecessary and reduces an investor’s income. Even laddered strategies investing in high quality mortgages or asset-backed securities must rely on issues with stable and predictable structures that have lower yields as a result.

A passive, laddered portfolio can also give up potential alpha because it commits to interest rates and yield curve strategies on the day the ladder is created, and every year or two, when bonds mature. Although yield curves change frequently, a ladder does not adjust during periods of changes in the curve, potentially missing significant opportunities. Also, the laddered investor redeploys cash further out on the yield curve immediately after bonds mature. The timing of this reinvestment may not always be optimal.

Second, even though bond maturities may be diversified, laddered portfolios can suffer from a lack of sector diversification. Typically, laddered strategies have restrictions on the types of bonds in which they can invest. As a result, they often must purchase, at a premium, those issues that are most in demand. This can render portions of the fixed income universe inaccessible to laddered portfolios.

Third, to potentially generate additional alpha above Treasury returns, but still retain stable cash flows, laddered portfolios may take on more credit risk or cash flow risk. If bond prices deteriorate, the bond manager may need to replace maturities in a specific sector at an inopportune time. Also, passive managers must monitor the credit quality of a laddered portfolio constantly even though they may not have extensive resources devoted to credit research. Alternatively, a passive manager without the expertise or resources to analyze credit may not take any risk in the portfolio, which reduces the potential for generating alpha.

Finally, investors using laddered portfolios can be subject to certain liquidity and cash flow risks. Securities that will perfectly match liabilities without giving up return can be difficult to find. In addition, transaction costs can be high when cash flows change and liquidity and restructuring are needed. In an effort to improve returns, some taxable laddered portfolios are “tilted” by including more mortgage and callable debt. When applied “structurally” rather than “tactically,” this strategy produces only modestly higher yields while putting total return at risk by adding volatility that most passive managers are unable to evaluate and respond to.

Advantages of Active Management

A core active manager with expertise in all sectors of the global bond market is more likely to identify a variety of opportunities to add value in a diversified structure that can potentially provide more liquidity for unexpected cash flows than laddered portfolios. Active strategies are more likely to produce higher returns than ladders, with limited changes to overall portfolio risk, due to:

• Bond market inefficiencies. Often the result of restrictions on passive strategies (including maturity ladders), inefficiencies in the bond market provide both structural and tactical opportunities to generate returns that should exceed those of benchmark indexes.
• Diverse sources of value-added. Active managers with extensive resources and expertise across all sectors can identify many small and diverse sources of value, which should boost returns on a consistent basis without altering risk levels. Active management can also offer greater flexibility than bond laddering. By selecting individual investments on an ongoing basis, which can include both buying and selling securities, active managers can take advantage of market conditions to reap potentially higher returns and also to hedge a portfolio from the risks in fixed-income investing, including credit risk and interest-rate risk. Active management can provide the additional benefit of tax-sensitive management; tax management is not a key component of, or even factored into, the management of a laddered portfolio. Examples of the flexibility available to active bond managers versus a passively managed laddered maturity portfolio include:
• Duration management. Active managers have the ability to adopt a defensive stance in anticipation of rising interest rates by lowering duration (and thus lowering the portfolio’s price sensitivity to changes in interest rates). A laddered portfolio tracks a consistent duration that cannot be easily, or quickly, adjusted to a rising interest rate environment.
• Yield curve positioning. Active managers may enhance returns as interest rates fluctuate through changes in the position of the portfolio across the yield curve. Interest rates of varying maturities tend not to rise or fall uniformly, allowing the active manager to overweight or underweight specific areas of the yield curve in an effort to enhance returns. Laddered portfolios, as noted above, commit to the shape of the yield curve when funds are invested.
• Sector and credit diversification. By identifying overvalued or undervalued sectors, active bond managers can weight portfolios accordingly. For example, in an improving economic environment with rising interest rates, a manager might overweight the corporate sector relative to the index and then underweight corporates if the sector becomes overvalued. In addition, if a manager believes that rates will rise in the U.S., but not in Europe due to slower growth, the portfolio can be invested more in European versus U.S. bonds. For the tax-sensitive investor, the active manager may choose to avoid certain state credits during periods of financial stress.
• Structural premiums. Active managers have the ability to capitalize on term, liquidity, credit, and volatility premiums to add potential alpha that laddered portfolios are unable to capture. For example, active managers have the ability to emphasize the powerful roll down effect in a very steep yield curve environment, while laddered portfolios can only mimic the curve structure. An active municipal manager will also consider the effects of market discounts in a rising interest rate environment.

Conclusion

Although bond laddering is a common passive investment strategy, it has inherent limitations. The bond market offers active managers significant structural and tactical opportunities to potentially produce higher returns than laddered portfolios, an increasingly important consideration because total returns on financial assets are expected to be modest in the coming years. Core and municipal active managers can potentially create greater alpha and thus higher pre- and after-tax total returns than passive, laddered portfolios because active managers can exploit a number of inefficiencies and small, diverse sources of value in the bond market. In addition, active managers can utilize several techniques, such as duration management, yield curve strategies, sector rotation, security selection and tax management, which have the potential to provide excess returns and risk management not available to passively managed, laddered portfolios.