Bond laddering with iBonds® ETFs
Apr 25, 2022
KEY TAKEAWAYS
• Bond ladders can be used to hold bonds to maturity during rising rate environments.
• Implementing ladders in practice can be time consuming and inefficient.
• iBonds ETFs are term-maturity ETFs that can simplify the process of building a bond ladder.
THE CASE FOR BOND LADDERING
With interest rates increasing in 2022, many investors are looking to navigate the market and not lose money on bonds. Bond prices typically fall when interest rates rise. One strategy is to buy a bond and hold it to maturity. Another approach is bond laddering. Bond laddering is the practice of buying bonds that mature in consecutive calendar years, and then reinvesting proceeds from bond maturities into new bonds that extend out the ladder.
For example, instead of buying a single five-year bond and holding it to maturity, consider building a five-year ladder with bonds that mature each December for the next five years. When one bond matures, a new five-year bond is purchased with the proceeds (see illustration). Bond laddering potentially provides investors with stable cash flow. Each year, new money from a maturing bond and the semi-annual coupon payments from the bond can be reinvested.
The ability to manage exposures on a yearly basis can be especially beneficial in a rising rate environment. As interest rates change, each bond in the ladder should have a similar total return as the average yield at time of purchase. By locking in a yield at the beginning, the ladder may help insulate the bond buyer from price losses if the investor holds to maturity.
5-Year Ladder Illustration
Source: BlackRock
Image description: Bar chart showing 20% of the portfolio allocated to each of the 5 years in a hypothetical bond ladder. An arrow represents that after the first year, proceeds from the maturing bond can be reinvested in the Year 6 bond.
CHALLENGES TO LADDERING INDIVIDUAL BONDS
As with a lot of things, however, this strategy is simple in theory but can be more complicated in practice.
The first challenge is selecting the bonds. Should you go only to an issuer that you know? The highest-yielding bond? Or the one with the best credit rating? Researching the credit quality of the issuer requires access to information and the know-how to evaluate relative value between bonds. Even for experienced investors, this can be daunting.
Once you’ve decided to purchase a bond, consider the transaction costs. Many bonds have minimum sizes to buy and trade. If you don’t have a large amount of money to invest, the ability to diversify and spread credit risk across multiple issuers can be difficult. As a result, you might end up with a concentrated portfolio from only just a handful of bond issuers.
Liquidity, or the ability to convert the bond into cash, can be challenging for holders of individual securities. If you want to sell a bond prior to maturity, you’ll need to find another buyer in the over-the-counter bond market, which might take time. If your bond has a call feature, you could get repaid early if the issuer decides to refinance its debt. In that case, you face reinvestment at lower yields.
BUILD BETTER BOND LADDERS WITH iBONDS ETFs
Many investors use mutual funds and exchange traded funds (ETFs) to overcome some of these hurdles. Traditional funds usually hold a diversified portfolio of bonds and have a portfolio manager who oversees the fund. Because traditional funds don’t have maturity dates, the investor would need to sell a portion of the fund if they wanted to take money out of the strategy.
Explore laddering with the iBonds Ladder Tool
Term-maturity bond ETFs, such as iShares iBonds, can help investors build more efficient bond ladders by combining the reinvestment control of individual bonds with the convenience of an ETF.
- A known maturity: All of the underlying bonds mature during the calendar year in the fund’s name. For example, the bonds in the iShares iBonds Dec 2022 Term Corporate ETF (IBDN) mature between January 1st and December 1, 2022. When the last bond matures, the fund returns its final net asset value to shareholders in cash.
- A potentially smoother income stream: Defined-maturity bond funds aim to make monthly distributions of income, which can be smoother than the lumpy coupon payments of a bond ladder.
- Diversification: Each ETF holds multiple bonds. The US Treasury iBonds ETFs hold government bonds with maturities throughout the year. The municipal and corporate iBonds ETFs hold hundreds of bonds, which reduces exposure to single large issuers.
- Tradability: While individual bonds are traded in the over-the-counter bond market, iBonds ETFs can be traded throughout the day on an exchange at a known price.
- Low cost: ETFs often have lower transaction costs than over-the-counter bonds. Annual expense ratios are low as well. iShares iBonds ETFs have management fees ranging from 0.07% to 0.35%, depending on the sector.
Going back to our example of the five-year bond ladder, an investor could purchase five iBonds ETFs and gain exposure to hundreds of underlying bonds with known maturity dates, an income stream designed to be predictable, and an overall experience that’s simple and low cost. The iBonds Ladder Tool can help investors review yields, maturities, credit quality and sector breakdown of bond ladders in the US Treasury, investment grade, municipal and high income sectors.
