Virtues of Do It Yourself Bond Laddering
Bond ladders are frequently criticized in the financial media and even among some professional advisors (who, I would point out, are often able to use only bond mutual funds or ETFs). Earlier this week, we corrected some common misperceptions regarding individually tailored laddered municipal bond portfolios. Today we’ll move on to the many advantages of owning one.
The Benefits
- They avoid mutual fund expenses.
An important benefit of owning individual bonds is that they avoid the fees investors have to pay a fund manager.
- They offer complete control over credit and term risk.
Perhaps the most important benefit of owning individual bond securities is that investors take 100% control over the credit risk and term risk of their portfolios. They also take control over the timing of cash flows into and out of such a portfolio. This is particularly important to investors relying on their fixed-income assets to provide the cash flow they need to maintain their desired lifestyle (in retirement or otherwise).
A related issue is that municipal bond funds (and corporate bond funds) typically own bonds with call risk (the issuer has the right to prepay the bond). Those bonds carry slightly higher yields to compensate investors for taking this risk.
However, not only does that feature cause investors to lose control over the maturity of their bonds, the reinvestment risk that calls create can show up at the wrong time, when stocks are doing poorly. The issuer will call in the bond and investors now have to reinvest the proceeds at lower rates. If you are going to even consider buying a bond with a call feature, require that it have at least 80% protection (meaning a bond with 10 years to maturity has at least eight years of call protection).
- They avoid the impact of hot fund flows.
There’s another little-discussed benefit of owning individual securities. With a mutual fund, after a period of falling interest rates, “hot money” chasing recent performance will typically buy into the fund. The fund, therefore, must buy more bonds in a low-rate environment, thus lowering the average rate for all investors. Then, if rates begin to rise, the hot money will often leave, forcing the fund (and long-term investors in it) to suffer trading costs and capital losses that can’t be “waited out.”
On the other hand, an investor who holds individual bonds, and who is satisfied with the yield to maturity when the bond was purchased, is not subject to the same problem (that is, other investors cannot force him to sell at depressed prices).
- They offer the ability to harvest losses at the individual security level.
Another advantage of owning individual municipal bonds is that in a rising-rate environment, investors have the ability to tax manage (harvest losses) at the individual security level rather than just the fund level.
Note that this option is a greater benefit with municipal bonds than it is with stocks. With stocks, when you harvest a loss, you reset the basis and eventually (unless you receive a stepped-up basis upon death) will have to pay a tax on the now-larger gain. Thus, your benefit is the time value of money. With municipal bonds, when you suffer a loss and buy a similar bond at a now-higher interest rate, you get the full value of the tax benefit because the higher interest rate you now earn is tax-free.
- They offer the ability to maximize after-tax returns.
Another key advantage of laddered portfolios is the ability to maximize the after-tax return on municipal bonds by tailoring holdings to individual investors’ state and tax bracket.
For example, the bonds of high-tax states (such as New York and California) tend to trade at lower yields (due to demand from their residents for double tax-free interest) than bonds from no- or low-tax states (such as Florida, Nevada and Texas). Unless you’re a resident of a particular high-tax-rate state, there is no reason to own their bonds because you can earn higher after-tax returns purchasing the bonds of low-tax states.
Yet if you own a national municipal bond fund (like those from Vanguard), you are going to hold a high percentage of bonds originating from high-tax states. For example, according to its 2015 annual report, the Vanguard Intermediate-Term Tax-Exempt Fund (VWITX) had about 15% of its holdings in California bonds and about 12% in New York bonds.
Some critics of laddered bond portfolios imply that lower yields on bonds from states such as New York and California is a reflection of their lower risk. Unfortunately, that is not correct. It’s a result of their higher tax rates, which leads to more demand for them from their own residents. This should be obvious, as similarly rated bonds with the same maturity from zero-tax-rate states such as Florida, Nevada and Texas carry higher yields.
Other Advantages
Clearly, there are some diversification benefits that come with a national bond fund, but you can get more than sufficient diversification buying bonds from the lower-tax-rate states. And as I noted earlier this week, if you limit your holdings to bonds of the highest credit quality (as I would recommend), there is far less need for diversification.
Another benefit of bond ladders is that investors can take advantage of the differences in the shape of the yield curves between taxable and municipal bonds. Because the municipal bond yield curve is typically steeper than the yield curve for Treasury bonds, there are times in which even higher-tax-bracket investors can benefit from buying taxable bonds or FDIC-insured CDs for the shorter maturities in their ladder and municipals for the longer end. This has often been the case over the past five years for even some of the highest-tax-bracket investors and for maturities of up to five years.
Finally, bond funds may contain municipal bonds that generate income subject to the alternative minimum tax. Fund managers buy such bonds to boost the yield, attracting less-knowledgeable investors. These bonds can be avoided when building your own portfolio.
Summary
When it comes to investing in equities, in general, mutual funds provide a major advantage over individual securities because of the need to diversify the idiosyncratic risk of stocks. However, if investors limit their municipal bond holdings to only the highest-quality issues (the only type of bond I recommend), there’s very little need for diversification. What’s more, you’ll be able to take advantage of the times when taxable investments provide higher returns than municipal bonds.
Given the many significant benefits that individual bonds can provide, if you or your advisor has access to institutional pricing and your portfolio is in the area of $1 million or more, you should consider owning individual municipal bonds. I recommend that $1 million threshold to achieve sufficient diversification levels.
And when it comes to taxable investments, because Treasurys and FDIC-insured CDs have no credit risk, and you can buy small amounts, there simply is no need for mutual funds, except for their convenience, or inside of corporate retirement plans where CDs are not generally available.
If you are using a financial advisor who invests in bond mutual funds instead, ask her to explain why. Now that you’re educated on the issues, you are well-armed to address the canards typically raised.
This commentary originally appeared July 13 on ETF.com
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