Facing Uncertainty With Laddered Fixed-Income Portfolios

There is something of a false conception among investors that bond ladders are by design rigid and inflexible investment vehicles.

Jeff Klingelhofer, portfolio manager on Thornburg Investment Management’s global fixed-income strategies, speculates this may be at least in part because of the image conjured up by the naming convention. Investors hear of “five-year ladders” or “10-year ladders” and they imagine locking their money away the better part of a decade, but this is not accurate, Klingelhofer warns.

When he is describing the handful of laddered fixed-income portfolios he oversees, he advises investors to focus more on the stacked rungs of the ladder and how they build on top of one another, rather than on the approach’s rigidity.

“Frankly, people often overlook the benefit of having a laddered portfolio in this current market context,” he explains. “They don’t know much more than the basic structure is to have, in a limited-term ladder, roughly 10% of the portfolio in bonds in each of the first 10 years of the yield curve.” That means 10% of the bonds in one-year bonds, 10% of the bonds in two-year bonds, 10% of the bonds in three-year bonds, and so on. For longer-term bond ladders, it’s the same concept, but rolled out further along the yield curve—perhaps one to 20 years with 5% of the portfolio invested in each year.

“If you think about it, this is far from a rigid approach to investing your money,” Klingelhofer suggests. “As the years move along, I continually have a cash flow coming back in from maturing securities, I can keep the ladder rolling and reinvest this with a fresh risk perspective. For income-focused investors, i.e. retirees, a gradually rising rate environment is actually a fantastic environment for these laddered portfolios over time. It leads to durably higher spending ability for the end-holder of these investments.”

NEXT: Pros and cons of laddering 

Klingelhofer observes that the “biggest pushback” that he hears about using bond ladders in a rising rate environment goes like this: “OK, if rates are going to rise and you have strong conviction this will happen in the short-term, why not just invest all your assets in one-year duration bonds? It’s a bull market so go with a bull strategy.”

There is some truth to this, Klingelhofer admits, but he says the narrow argument misses the bigger picture: “Image if the 10-year dropped to zero tomorrow. That would look  great for net asset value from a one-year perspective, but if you cash out the added value there would be really no way reinvest it effectively. Worse, as a retiree, if you spend the return on the net asset value, it is permanently impairing your asset base.”

This is the sense in which having a diversified rate exposure leveled out over five or 10 years (or longer) can be very helpful, in effect smoothing the ride and smoothing expectations.

“Having the income stream continually rolling off into our hands to reinvest at higher rates is a big opportunity,” Klingelhofer says. “And we don’t run a rigid bond ladder … It’s not 10% strictly going into each year duration from now until 10 years out regardless of the rate environment. There is a basic structure, but there is flexibility as well that lets us assess the risk-reward spectrum over time.”

The recent environment certainly underscores the importance of durability and flexibility. With the 10-year Treasury sitting at 1.5%, as it was in the middle of 2016, risk and reward by anyone’s estimation was significantly skewed toward risk. “But here we are today at 2.5% and the picture is more balanced, so we have been rebalancing our ladder as well,” Klingelhofer says.

NEXT: Ladders across environments 

Again, when it comes down to it, if one knew for sure that rates were going to rise and they knew the timing, it would be the correct argument to go shorter with everything.

“But we all know that the world is a relatively unpredictable place from a macro perspective,” Klingelhofer concludes. “It is possible to make broad forecasts about where the U.S. is going in terms of reaching potential GDP [gross domestic product] growth and all of those things that might impact rates … but when push comes to shove it is very difficult to get your predictions spot on.”

So the basic philosophy must be, according to Klingelhofer, “build the fixed-income portfolio brick by brick with a bottom-up perspective … thinking about assembling the portfolio piece by piece so that it can thrive across a lot of different potential outcomes.”

Looking ahead, Klingelhofer and others have speculated that markets are still pressured upward on rates, but there are a number of constraints that he thinks will prevent the U.S. from seeing a 4% 10-year Treasury note during 2017. And, he observes, these factors could combine with unexpected difficulties to reverse the picture entirely.

“Global rates are still very low around the world. There are some positive economic indicators that have come out of Europe, but China is still a big question mark for global growth,” he says. “Our basic belief is that inflation will continue to tick higher on the back of wage pressure—having the Fed in play doesn’t necessarily allow for U.S. potential growth to move durably higher in the near term. So most estimates, mine included, peg potential GDP growth this year right around 2%, which is where we are today.”

NEXT: What does 2017 have in store? 

Important to note, market research published so far this year shows equity returns alone will likely not improve the funded status of pension plans or the outlook of other long-term investors who have to carefully control risk. Thus a rethink of the fixed-income portion of the portfolio may be timely.

Jim Ritchie, a partner in Mercer’s retirement business, observes that many pension plans have large exposures right now to fixed-income assets “with durations much shorter than their liabilities, resulting in a significant bet on interest rates going up in the future.”

“While most pundits believe interest rates will go up in the long run, it is the short run that creates havoc on plan sponsors’ balance sheets and income statements,” Ritchie warns. “Another interesting development this year will be the release of the Financial Accounting Standards Board (FASB) update for recognizing pension expense. This update may result in a reduction in the amount of expense recognized as operating expense with the remaining amount essentially falling ‘below the line.’ These two issues should encourage plan sponsors to rethink their asset allocation strategies for their pension plans.”

PLANADVISER has received a lot of commentary on the question of whether rates will in fact rise during 2017 and beyond. One interesting observation comes from the portfolio managers at Osterweis Capital Management, an investment provider focusing on wealth management and institutional investors.

“The choice is really one of either believing that we will break out of our slower, sub-par recovery, enabling rates to normalize over the next few years or a continuation of the vicious cycle of low growth begetting very low interest rates,” they say. “We imagine if investors were polled at the end of 2015, not many would have correctly predicted the events of 2016. After getting off to a rough start, high yield was a standout performer. Equities were quite subdued until after the election and investment grade bonds were looking to notch up a pretty good year until animal spirits released the ghost of inflation and rising interest rates. Looking at 2017, the real question for investors is: Is the rally we have seen in equities and high yield sustainable, or is it a head fake?”