By Terrance Hults
Fearing rising rates, some municipal investors have sought protection in passive laddered portfolios. The strategy’s seeming simplicity packs a lot of allure - but also hidden risks.
Investors who build traditionally laddered portfolios to protect against rising rates are likely to be disappointed by the low yields they’ve locked in. And some investors - particularly those who build higher-yielding ladders - are taking on a surprising amount of volatility. Last autumn, investors in five- to 15-year ladders learned the hard lesson that risks should be actively managed.
Kicking Away the Ladder
Laddered portfolios are built with bonds spaced evenly across maturities so that the proceeds are reinvested as each bond matures. The traditional ladder is a 10-year one in which the investor purchases a 10-year bond, a nine-year bond and so on, down through a one-year bond. A year later, when the one-year bond matures, the investor then buys a new 10-year bond so that the ladder resembles its original configuration in terms of maturity.
These portfolios are simple to construct and maintain, provide relatively certain return, and gradually capture higher yields as interest rates rise.
But here’s the first hitch. In today’s low-interest-rate environment, that return is going to be locked in at low levels - levels even below the Fed’s inflation target. For example, portfolios laddered from one to 10 years yield only about 1.8% today - and that’s before accounting for trading costs and other fees.
At that yield level, there’s little chance to beat even a modest rate of inflation. And if inflation isn’t yet on your list of concerns, it should be.
Too Little, Too Late
Another hitch? While it’s true that passive laddered portfolios capture rising yields, it takes a long time for the investor to receive any meaningful benefit.
When interest rates rise, an investor in a laddered portfolio has to wait until the shortest bond matures in order to purchase a longer bond at a new higher yield. Playing the waiting game often means missing out on opportunities, including adding value through fluctuations in interest rates.
Investors in actively managed municipal portfolios, meanwhile, are in a much better position to benefit from rising yields.
To begin with, active managers can pursue a tax swap strategy: selling bonds bought when yields were lower, realizing a loss for tax purposes and buying a new higher-yielding bond.
In addition, active managers can boost a portfolio’s return by taking advantage of “roll” - the tendency of a bond’s value to rise as it becomes a shorter bond - by buying bonds with high return potential due to extra roll and by selling those whose values are likely to fall.
For another thing, active managers have the flexibility to shift among municipals and taxable bonds and municipal credit as relative after-tax yields change. After all, the market isn’t static.
Which leads us to our final point.
Tying Down Those Risks
The third problem with passive ladders is risk. Market risks are just as relevant and just as dynamic as yield and return.
Nonetheless, some municipal investors who want to boost their yield when passively investing inadvertently increase their risk too. Laddered portfolios sometimes include lower-credit-quality bonds, which increase credit risk, or longer-maturity bonds, which increase interest-rate risk.
For example, some laddered portfolios boost overall yield by shifting the entire ladder to a five- to 15-year structure. Not only do investors have to wait significantly longer to experience the benefit of reinvesting when rates rise, but this strategy has more interest-rate risk than nearly any general approach to municipal investing. As investors learned last fall, that can translate into significant - and painful - volatility.
So while it’s true that there’s nothing inherently wrong with owning lower-quality or longer-maturity bonds, it’s locking them in and not monitoring them that are potentially dangerous.
When markets are on the move, investors need to stay nimble, not locked in. Active management provides access to multiple sources of after-tax income and return potential, while also providing greater liquidity, diversification and risk control. That makes it a prudent choice for navigating a dynamic investment environment - whether that means rising interest rates, rising inflation expectations or unfolding changes to tax policy.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.