Bond laddering is a popular strategy among investors seeking steady returns and income, particularly when interest rate conditions are uncertain. As I've written about elsewhere, laddering is the practice of buying bonds that mature in consecutive calendar years, and then reinvesting the proceeds from maturing principal into new bonds that extend the ladder out another year.
Defined-maturity bond exchange traded funds (ETFs), such as iShares iBonds ETFs, make building bond ladders more efficient by combining the control of investing in individual bonds with the convenience and diversification of an ETF. For example, an investor could build a five-year ladder by purchasing five defined-maturity ETFs, thereby gaining exposure to hundreds of underlying bonds with known maturity dates, monthly income stream potential, and an overall experience that's vastly simpler than do-it-yourself.
Most investors choose to ladder municipal and investment-grade corporate bonds, but some might want more income than these bonds currently yield, as shown in the chart here.
There are some important differences between investment-grade and high-yield bonds to note, however. For one, security selection becomes even more important for a high-yield bond ladder, since these bonds have higher credit or default risk than investment-grade securities. Also, more than 80%1 of the high-yield bond market is callable, meaning the money can be returned early by the issuer. If a bond gets called early, investors will have to reinvest the money in another bond, potentially at a different interest rate; that uncertainty can make it difficult to maintain a steady cash flow and specific maturities as they move "up the ladder."
That's where defined-maturity bond ETFs can be a game changer.
How high-yield iBonds ETFs work
The iShares iBonds 2021-2025 Term High Yield and Income ETFs invest primarily in high-yield corporate bonds. The funds have several important features:
- They have the flexibility to include BBB-rated bonds if certain market conditions are met. Because these investment-grade bonds are much less likely to get called, adding them would help the fund to mature at a set date, should the high yield bonds get called.
- To help cushion the funds against defaults, bonds are removed when the dollar price of the bonds falls below $60, or into distressed territory. (Remember, bonds are $100 at par.)
Add it all up and investors have a vehicle to build ladders with greater income potential, diversification and the simplicity of an ETF.
1. Source: Bloomberg Barclays, based on the Bloomberg Barclays US High Yield Bond Index as of 4/30/19
This post originally appeared on the BlackRock Blog
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