Many investors today are seeking both income and certainty. Some financial advisors are addressing these needs by building bond ladders, which have a visible stream of income and staggered maturities that many clients find comforting. Other advisors use bond funds as a source of portfolio stability. This raises the question: what are the relative advantages of these two strategies?
Bond funds should always be used for non-investment-grade bonds. With fewer bonds in a typical ladder vs a fund, the higher default risk of speculative-grade bonds creates too much risk in a laddered portfolio. In a five-year period, one study found that more than one in four Canadian bonds rated by Moody’s Investors Service Inc. as speculative had defaulted.
A central argument for using bond funds over ladders is the superior diversification of the funds. A tenet of modern finance is that investors do not get paid for bearing risks that they can diversify away. Contrast a typical bond ladder, for example, that might contain 10 to 30 bonds with the almost 600 bonds in iShares DEX Universe Bond Index Fund, which is managed by BlackRock Asset Management Canada Ltd. of Toronto.
Bond funds have other advantages over bond ladders. The greater scale of bond funds allows the trading of bonds at lower bid/ask spreads than is the case for retail accounts. A fund’s liquidity also allows greater ease of investment and liquidation. Interest payments are reinvested in a more timely fashion in a bond fund than in a typical ladder. A bond index fund also can have more stable risk characteristics (e.g., duration, credit quality) than a bond ladder, for which both duration jumps after reinvesting a maturing bond and the credit quality of new bond additions can vary.
Historically, the high fees associated with actively managed bond funds have negated much of their benefits. Vanguard Group Inc. has calculated that actively managed bond funds in Canada had an average management expense ratio of 1.3% as of Dec. 31, 2010. However, with the explosion of exchange-traded funds, clients can access broadly diversified bond funds at an extremely low cost. Vanguard Canadian Aggregate Canadian Bond Index ETF, for example, has a management fee of only 0.2%.
Nevertheless, bond ladders also feature certain advantages, particularly for affluent investors. Specific bonds can be added to a ladder to match future cash flow needs. And longer-term bond ladders (e.g., 10 years) also offer reasonable stability of income once fully invested.
Clients with large accounts or firms that can buy in bulk on behalf of all of their clients can avoid the MERs associated with funds while still accessing reasonable bond pricing. Furthermore, as laddered strategies allow bonds to mature, transaction costs are incurred only on purchases. Bond funds and ETFs can have much higher turnover and transaction costs as a result of either active trading decisions or index replication requirements.
Bond ladders can exploit illiquidity premiums and/or pricing inefficiencies. For example, bonds of Canadian Crown corporations guaranteed by Ottawa typically trade at a premium to federal government bonds. Ladders also allow ongoing tax management, such as tax-loss harvesting. Finally, bond ladders appeal to the loss-averse nature of investors. The certainty associated with knowing that a bond held to maturity will be redeemed at par (barring a default) regardless of interest rates levels can help clients sleep at night.
Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own securities mentioned herein.
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