7 Reasons why bond ladders are bad for investors

When interest rates rise, or are expected to, stockbrokers urge conservative investors to buy individual bonds. They appear to be safer than bond mutual funds. Just this week, I caught the following headline in an investment publication: “Individual bonds can help protect income.”

That’s 100 percent wrong. Individual bonds deprive you of extra income when interest rates go up, as well as expose you to other risks. Investors who understand the trade-offs choose bond mutual funds.

This goes against convention wisdom, so I’ll start with a quick explainer before listing all the reasons for my choice.

In a bond mutual fund, the managers constantly buy and sell bonds. The daily share price of the fund reflects the bonds’ current market value, minus fees. When interest rates go up, bond values go down – and so does the share price of bond mutual funds. If you sell, you might not get your original principal back. When interest rates fall again, as they will in the next business cycle, your share price will go up.

Investors who hate to see share prices fluctuate buy individual bonds, usually in bond ladders. That’s a series of bonds maturing at different times. A typical ladder might contain one-year, three-year, five-year, 10-year, and 20-year bonds. Each time a bond matures, you can spend the money or reinvest in more bonds. The market value of these bonds fluctuates, too, but you don’t see it. People who choose ladders plan to hold to maturity, at which point they’ll get their original principle back.

Now for my case against ladders:

1. Bond ladders deprive you of current income. The money you put into individual bonds pays you an income at a fixed rate. When rates in the marketplace go up, your income will stay the same. In a bond mutual fund, by contrast, the managers will be adding higher-rate bonds to the pool. Your interest income – and spending money – will increase.

2. Bond ladders often force you to reinvest at lower rates. If you’re not spending the interest income you get from individual bonds, you need to reinvest it. What are you doing with that money? It might not be enough to buy more than one or two bonds, at a high commission cost. If you want that money to be readily available, you’ll siphon it into a money market fund whose interest rate is kissing zero.

In a bond mutual fund, by contrast, you can reinvest all your interest income in new shares, at the market’s current, higher yields. In other words, you’ll be buying more shares at a lower price. When interest rates decline again, the value of your bond fund shares will rise. You’ll have more shares than you started with, which means more dollars in your pocket.

3. Bond ladders deprive you of future capital gains. When you hold individual bonds and interest rates decline, your bonds will rise in market value. They’ll be worth more than you paid for them. But in ladders, you hold to maturity so you’ll never collect the capital gains. In a mutual fund, the manager will harvest those gains and add them to the value of your shares.

4. Bond ladders carry more default risk. Individual investors might hold no more than 10 or 20 bonds. If one of them goes bad, it could take a mean slice out of your portfolio. Ladders should be built only with high-quality bonds but – in municipals, especially — you never know when a snake is hidden in the underbrush.

Mutual funds are far better diversified, owning hundreds, even thousands of bonds (Vanguard’s Intermediate-Term Tax-Exempt fund holds 4,641 of them). Like ladders, the bonds come in varying maturities, from short to long.

5. Bond ladders leave you unprepared for emergencies. Sometimes, you can’t hold individual bonds to maturity. You might have unexpected medical bills or one of your kids might need some cash. You might have inherited the bonds and want to convert them into cash. Selling bonds before maturity is more expensive than you imagine. If interest rates have risen, their market value will be down – especially for small, retail lots. The markets trade in amounts of $100,000 or more, and clip 2 to 3 percent off the price if you’re selling just 25 or 30 bonds. You pay your broker a sales commission. And, after the sale, you don’t have a ladder any more – one or more of the rungs is gone.

With a mutual fund, on the other hand, you can sell shares at any time and at no cost if you have a no-load fund. The remainder of your investment will be just as diversified as it was before.

6. Bond ladders are expensive. You’ll probably work with a broker to set one, paying 2 percent in markups, at retail price. The ladders have to be managed, meaning more sales commissions. A no-load mutual fund, by contrast, charges no commissions and costs only a small amount per year in management fees – at Vanguard, about 0.2 percent. Also, funds buy their bond at institutional prices, which are much lower than the price you pay in the retail market. .

7. What about other kinds of ladders? Ladders built from certificates of deposit instead of bonds face many of the same drawbacks: No increase in income when interest rates rise and a penalty if you’re forced to sell before maturity. The same is true of ladders build from Treasury securities. But there’s no default risk and you don’t have to pay sales commissions (for Treasuries, you’d have to build the ladder yourself, using Treasury Direct).

Bottom line: “Investors are hurting themselves, when they choose ladders over funds,” says Francis Kinnery, a principal in Vanguard’s Strategy group. Ladders serve an emotional need for certainty, which might matter to you more than anything else. Just don’t think that this move outwits the markets. Nothing does.

Read More:

Why It’s Still Smart to Own Bond Mutual Funds

6 Safe Ways of Investing in Tax-Free Municipal Bonds

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21 comments
Jim Kirk // 01/31/2011 at 4:34 pm

Jane,
What is your critera for buying a municipal bond? At time tax they seem like a good deal, but the yields are relatively low. For example consider the following mutual funds together with 10-year yields:
Vanguard Tax Exempt Massachusetts 4.38%
Vanguard Intermediate Term Investment grade 6.36%
Thanks

Reply
Jane // 02/07/2011 at 3:23 am

My criteria are high quality (this is the safe part of my investing) and a yield that gives me more after tax than a taxable bond.

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Howard Heahlke // 01/31/2011 at 9:34 pm

We currently have our fixed income funds in Vanguard Bond Index fund. I was beginning to think of laddering some CDs, or government bonds because of inflation worries. You have given me more to think about.

Howard Heahlke

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John Caldeira // 02/01/2011 at 2:48 am

Hello Jane,

I must ask: After your negative assessment on bond ladders, and knowing what bond funds do in rising interest rates, what DO you recommend for a typical middle-aged investor, for the bond portion of one’s portfolio?

John
PS: Your early edition of “Making the Most of Your Money” was a major influence on my investing. Thank you!

Reply
Jane // 02/07/2011 at 3:26 am

Well, I still own bond funds, for the reasons I stated. Floating-rate notes are interesting, as long as you feel comfortable with the credit risk. And thanks for your kind words about my book!

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Tony Noto, CFA // 02/01/2011 at 3:09 am

Hi Ms. Quinn, I disagree with a number of these points. Bond funds become particularly problematic when rates get really low, as hot money comes flooding into the asset class – and when rates eventually rise and the hot money leaves – long term investors will be left with losses they can’t simply wait out to become whole again.

I agree with your points against muni’s and corporate bonds for ladders though – in terms of expense and risk, which is why I avoid them.

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Jane // 02/07/2011 at 3:21 am

High-quality bond funds generally vary very little in price –maybe 10% up or down. You make your long-term money from dividends reinvested. The hot money goes more to junk-bond (high-yield) funds.

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Roger // 02/01/2011 at 3:23 pm

Hi,

Great advice, my broker was wanting me to start a bond ladder, I hesitated and instead kept by bond funds, I am very glad I did.

Keep the news letters coming!!

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Steven Weydert // 02/03/2011 at 1:57 am

All good points. Moreover, what happens when your 60/40 portfolio hits 65% stocks and you want to rebalance? You ever try to rebalance a portfolio of individual bonds? Unless you’re moving over $1,000,000 at any given time the frictional costs are typically too high.

Steven A. Weydert, CFP(r), MS
Weydert Wealth Management, LLC
Irvine, CA

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Jane // 02/07/2011 at 3:15 am

An excellent addition to the post. Thanks.

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Randy Moore // 02/07/2011 at 10:54 pm

Great points, Ms. Quinn. So glad I found your website. I had been tempted to go the bond ladder route. Your advice is solid. Thanks

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Frank Comprelli // 02/18/2011 at 2:24 pm

I question your comment about income increasing in a bond fund when rates increase. I think it’s more likely that income will stay more or less level because the $ base for the higher rates is lower.

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Jane // 02/25/2011 at 11:46 am

If interest rates rise, and you hold a bond fund, the total return — income plus capital loss — will drop. If you don’t plan to sell, however, you won’t realize the capital loss, just as you wouldn’t realize it if you held an individual bonds. However, the interest income you get from your fund will rise, because the manager will be buying new bonds that are paying higher interest rates.

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Allyn B. Janes // 03/19/2011 at 9:10 pm

I have been holding the Total Bond Index from Vanguard, which has really taken a beating with yields down to 3.3%. I was thinking of dividing into thirds adding the Vanguard High Yield Corp Bond Fund and The Intermediate Term Investment Grade. This would bring my average up to 4.56%. Your thoughts? Also received a small inheritance $40K and wanted to put this into some income funds but the choices are overwhelming. Any suggestions?

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Jane // 03/20/2011 at 2:44 am

High-yield gives more current income but also more risk and a more volatile price. These funds behave more like stocks. When you say you’re looking for an income fund, do you mean stocks? You might look at Vanguard’s Balanced Fund. Don’t get fancy, stay simple.

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John Peterson // 04/09/2011 at 7:41 pm

In your 2/25 post, referring to bond funds, you say “If you don’t plan to sell, you won’t realize the capital loss.” But I DO plan to sell!

Here’s my situation: my wife and I are both 75. We’re tired of riding the roller-coaster stock market, and want to take part of our IRA and create an income stream more akin to a pension. We plan to draw that down to zero over a 20-year period — if we’re still around then we have other assets we can turn to, but that we’d rather leave to our kids.

I’ve set up a mock bond ladder, made up of bonds recommended in Richard Lehmann’s newsletter and having maturities ranging from 2 to 8 years. I’ve run a 20-year cash flow analysis, assuming the bonds would all be sold at par value and rolled over into new 8-year bonds having the same price and yield characteristics as the initial 8-year set. I roll a set over each year, taking out some of the capital which when added to that year’s interest gives me the total annual income I need.

My model tells me that committing 75% of my IRA to the ladder will yield the income necessary to meet all our current needs except for travel, at current price levels. This lets us sleep soundly at night. The other 25% can stay in equities and pay for travel, more dining out, and emergencies. The ladder runs out in exactly 20 years.

This looks good to me! I’ve assumed yields stay steady at current levels. If inflation sets in, which seems likely, they should go up and the price of new bonds will drop. Thus, the ladder protects us against inflation. What’s wrong with my thinking?

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Jane // 04/11/2011 at 11:45 pm

Your plan could work out fine. Providing for the income you need, with an equity pot for potential growth and discretionary spending, is exactly the way a retirement plan should be set up. If inflation sets in, you will need to take more of your capital out each year, to maintain current spending levels — I suggest you stress-test for that. If interest rates fall in a rollover year, you will buy bonds at a higher price — you might stress-test for that, too. The key is never to sell before maturity (you said you DO plan to sell) — always let the bonds go to term and roll over at par (be sure you have non-callable bonds so they don’t come back too soon).

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Richard L P // 11/12/2012 at 9:54 am

Question?
I’m new to Trading, and im currently looking at investing.
Starting with 5,000 what would be a good portfolio for a 5 to 10 year term with minimal risk and good gains. including short term-
anybody with good succesful advice for making a nice security nest egg for new family?

Reply
Jane // 11/16/2012 at 1:23 pm

“Trading” means buing and selling in the hope of short term gains, paying brokerage and other expenses with every trade. That’s not the way of building a long-term nest egg for a young family. In you’re young and won’t touch the money, you go heavily into stock-owning mutual funds, preferably no-load funds with no sales expenses. The “go-nowhere” market we’ve had since 2000 will eventually come to an end, and embark on a long, new period of rising prices. Young families can afford to invest now and wait.

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Jerry // 01/06/2013 at 7:20 pm

Good points. However, you should mention that if you have an advisor and are invested in bond mutual funds, you are typically paying a percentage usually 50-100bps above and beyond the 20bps fee on the fund. Or you have a total return fund where costs are 60-120bps and have C shares so costs are typically higher there too. Both have pros and cons and the key is knowing your individual sitaution or client situation. These points are most valid for those doing their own investing without an advisor.

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Jane // 03/04/2013 at 5:58 pm

that’s a good reason to use no-load bond funds, such as Vanguard’s.

Reply
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