Getting The Returns Without The Risk

 |  Includes: SPY, TLT
by: Dale Roberts


A bond ladder can typically deliver the total return of the longest dated bond within the ladder.

Bond laddering can greatly reduce the chance of having a negative year, even within a bond bear market.

What's the sweet spot for the duration of a bond ladder if one fears a rising rate environment?

Many will write that bonds hold an incredible amount of risk due to the fact that rates are low. Being an investor who is 50% invested in bonds, of course, I have had a look at the worst case scenario for bonds in articles here and here. It's true that bonds hold initial and immediate (and perhaps ongoing) price risk when bond yields increase. Though generally those risks appear to be exaggerated in the media and on Seeking Alpha.

A 10 year Treasury bond could see an initial price hit of 8% with a rate increase of 1%. That bond price could move lower as well over coming years if yields continue to move higher. Investors should certainly be aware of the price risks of bonds and manage their portfolios accordingly. Many will suggest that investors keep their bond portfolios or funds to the shorter end of the yield curve, perhaps a weighted average in the area of 5 years, or less.

Another tried and true method for investors is to ladder bonds. That is to purchase a series of bonds that mature every year from a start date. One might buy 1, 2, 3, 4, 5, 6, and 7 year bonds of their choice whether that be corporate bonds or Treasuries. Every year there are bonds maturing and offering the yield and bond price for reinvestment. If rates are moving higher, that investor is able to purchase that higher yield. If rates have moved lower, that investor has some capital gains available for reinvestment; he or she has made money. An investor balances price risk with annual reinvestment. It can smooth out returns, and even better, laddering bonds can provide the returns of longer-term bonds with much lower price risk and volatility.

Laddering short-term and intermediate-term bonds captures most of the return of longer-term bonds, with less volatility. For example, a 10-year ladder can produce the return of 10-year bonds, but with lower risk because of its five-year average maturity.

It doesn't matter which way interest rates move. In fact, many of us would like to see rates move higher in a modest and consistent trend (that's if we can get the best of all worlds). With a laddering strategy, it's possible to get consistent returns. As many of us would write or rhyme to clients "every day is a good day to invest in the stock markets when investing for the longer term," well we should also add

"every day is a good day to start that bond ladder."

And what's the sweet spot (considering risk and returns) for bond ladders? According to Crestmont Research, a great resource for bond investors, the 5-7 year maximum duration appears to do the trick.

And here is the period showing various ladders and their returns.

Click to enlarge

The above graphic looks at bond ladder returns in an "unfavourable" environment for bonds. It was during a major bear market for bonds. Long-term Treasuries moved from an area of 2.5% in 1950 to over 13% by 1980. It wasn't just bad, it could be described as the worst bear market for bonds. It was a very aggressive move on rates over decades. But surprisingly there was money to be made with bond ladders.

The sweet spot for generating returns and limiting the downside on price or portfolio value is the 5 to 7 year ladders. When the average duration is shorter, the bond ladder portfolio is more nimble and able to quickly adjust and take advantage of the higher rates being offered. As we can see the 5 and 7 year ladders did not dip into negative territory. Though it should be acknowledged that those returns would not be beating inflation in some of those periods. As I demonstrated in this article, "What Do We Do When Nothing Works?", investors of all kinds were defenseless against the ravages of inflation in the event or period known as stagflation. Even stocks, the typical inflation fighter were no match for the inflation rates of the day.

And what about those bond ladders in the "good times," the bull markets for bonds.

Certainly bond returns are naturally a little more enticing during the bull market years of falling rates as bonds generally increase in price. But of course through every secular bear or bull market there will be periods of strong gains. Here's how the bond ladders average out through bull and bear markets.

Those are certainly some very solid returns. And of course that is largely what most investors are looking for with bonds; not home runs (beating the stock market in certain periods over the last 3 decades is certainly an outlier) but solid positive returns with the traditional risk management that bonds provide for balanced portfolios. Using bond laddering as the core of your bond portfolio will help reduce the overall balanced portfolio's volatility. Adding bonds reduces the portfolio volatility, using laddering can help reduce the price risk even further. Bond laddering can also be effective for retirees. In the drawdown phase, having one asset class that is largely in positive territory can greatly reduce the need to sell stocks - the core growth engine of a portfolio in the accumulation phase and spending phase. A very effective strategy for retirees would be a 1-5 year bond ladder combined with equities. A traditional 60% stock to 40% bonds (5 year ladder) balanced portfolio would provide very low volatility with the equity component providing the traditional inflation protection.

For my money, the ultimate lower-beta accumulation stage portfolio would include a traditional 60% or 50% stocks (using lower beta dividend stocks); the bond component would then be in the area of 80% 5-7 year bond ladder and 20% longer-term Treasuries to provide that inverse relationship to stocks. See this article on the very consistent trend; of bonds being able to go up when stock markets are severely shaken. Here's a very telling chart from that article with the S&P 500 (NYSEARCA:SPY) vs. longer-term Treasuries (NYSEARCA:TLT).

Click to enlarge

TLT would provide that stock market correction insurance and perhaps the best way to use that inverse relationship is to rebalance (trade) when the markets tank and TLT (hopefully) spikes. If you are using it as market insurance, it's best to cash in that policy and put the money to work in an asset class such as stocks that will then provide an opportunity. The moment when stock markets provide the lowest risk, is when no one wants to own them.

I would bet or hazard a guess that from today's (over) valuations that a balanced portfolio will again outperform an all-stock portfolio over the next several years. That has certainly been the case over that last several years; a typical 60-40 balanced portfolio, with rebalancing, would have outperformed the broader market from 2007 and 2008 with much lower risk. To not include bonds from today's date (while we are experiencing the 4th longest stock market run in history) may be a missed opportunity. We see many on Seeking Alpha who are new to investing, or new to self directing their investments, and they do not hold bonds - well they seem to hold them in contempt. In a few months or a year, or two, they will be wishing dearly that they held a bond portfolio.

Conclusions and suggestions

Remember, bonds do hold risk(s), but by laddering an investor can greatly reduce the price risk. But in the end we should remember that stocks are the best performing asset class over the longer term, and the trick is to be able to buy those stocks when they go on sale or at least offer reasonable long-term value. If you are investing on a regular schedule, or have cash ready to deploy then you may not need bonds if you are the rare type of investor who can withstand and even embrace a 50% or 60% market correction. But each investor should ask that tough question - how much of a correction can I handle with ease?

If you need price protection, bonds and cash are the typical tried and true holdings, no matter what are the yields of the day.

Happy investing and be careful out there.

Disclosure: The author is long VIG, SPY, EWC, EFA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Dale Roberts is an investment funds associate at Tangerine Bank (formerly ING Direct). Dale's commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.