2005 Lane Reports

Managing Risk in Bond Portfolios Through Laddering

Monday, August 1, 2005
by Kenneth N. Green, C.P.A., B.S., M.B.A.

Bond investors have a lot to think about whether they are simply rolling over CDs at a local bank or trying to actively manage a bond portfolio. Inflation rates, the direction of interest rates, credit quality, maturity and its cousin, duration, as well as trading costs are the most obvious concerns.

The impact of rising interest rates and inflation on their bond investments are concerns because conventional wisdom dictates that inflation is bad for bonds. True as this may be, it is difficult to determine when inflation is really a threat. However, it is not unusual for bonds to perform well in a modestly inflationary environment. As of May 31, 2005, consumer inflation was running at a 2.8% rate for the trailing 12 months. Despite the volatility, bonds have been strong for the past 20 years. This includes the years 1982, 1984, 1989 and 1991, when bonds had double digit returns while the inflation rate was above 4%.

Just as interesting is the fact that bonds can underperform in a low inflation environment such as in 1994 when returns were negative. The point to remember here is that a rising inflation rate as measured by the Consumer Price Index is only one of many factors that can affect bond market performance.

Though the U.S. inflation rate remains low by historical standards, it is showing signs of picking up in 2005. Non-seasonally adjusted consumer prices rose at an annual rate of only 1.6% in 2002, 2.3% in 2003, and 2.7% in 2004. The Federal Open Market Committee, the arm of the Federal Reserve which monitors inflation and oversees U.S. interest rate policy, noted in recent meetings that near-term inflationary pressures are building and that the labor market continues to improve. A tightening labor market warrants caution because it can drive up overall inflation and "core" inflation which excludes volatile food and energy prices.

This brings us to the concept of laddering bond portfolios. This typically is viewed as a passive investment style that does little to add value. We categorically disagree. The buy and hold laddered approach is a great way to take advantage of the front end of the yield curve without betting on the direction of interest rates. Laddering accomplishes two goals at once: it captures price appreciation as bonds age and their remaining life shortens, and it allows principal from maturing short-term bonds to be reinvested into new longer-term bonds. This strategy works well in rising, falling, and stable interest rate environments.

Based on historical patterns of bond fund purchases and redemptions, individual investors have tended to buy into bond funds at precisely the wrong time, when interest rates have bottomed and begun to rise. They also sell at the wrong time, when interest rates peak and then begin to decline.

Professional investors have not fared much better. Research has shown that most professional bond investors do a poor job of actively managing interest rate risk. At year end 2003 and 2004, with the ten-year Treasury note at 4.25% and 4.21% respectively, most "experts" predicted long rates would rise for the ensuing year. Predictions ranged between 5.0% and 5.5%. Instead they've recently been as low as 3.91% and are essentially unchanged today at 4.24%. A similar pattern has emerged worldwide. The reason is that U.S. and global core inflation have remained tame.

In employing laddering, we avoid making bets on both the direction of interest rates and on the magnitude of the changes. Although we enjoy guessing as to the direction of interest rates as much as Wall Street economists do, we believe that it is not prudent to put clients' investment dollars at risk based on our forecasts. Based on the slope of the yield curve, we will on occasion adjust the long end of the ladder when investing available funds. Today, with one-year rates approximately 3.5% and ten-year rates approximately 4.25%, there is little incentive to risk investing very long. With the discipline of laddering, we take the guesswork out of the investing decision.

Nonetheless, we still add substantial value to the security selection process by carefully selecting bonds with good fundamental credit characteristics. Also, we add value by carefully selecting bonds from different market sectors and industries since certain segments of the bond market are subject to price volatility due to factors other than what would be determined by interest rate changes alone. This provides the opportunity to buy good bonds at favorable prices.

We also are concerned about the structural elements of any given bond. These include the coupon, dollar price, any call provisions, maturity, sinking fund payments and escrow provisions. These elements can affect the price of a bond and its relative attractiveness as well.

 

 

 

These factors, along with the laddering process, all are part of the broader risk management process. We accomplish this by choosing strong fundamental credits and diversifying across issuers, sectors, and maturities. We avoid the higher risk opportunities because when it comes to missed opportunity versus lost principal we will choose the former path every time! Still, we are able to generate good returns over an economic cycle while limiting interest rate, reinvestment and credit risks. As we note the fundamental and structural characteristics of each bond we choose, the ladder will assure good yield.

We'll be pleased to help you develop and implement your bond strategy.

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Kenneth N. Green, C.P.A, B.S. (in Finance, University of Illinois), and M.B.A (in Finance, University of Michigan), is Senior Vice President and Director of Investments of Marc J. Lane & Company and Marc J. Lane Investment Management, Inc., the investment affiliates of The Law Offices of Marc J. Lane, A Professional Corporation.

 

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The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright © 2007 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.

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