From Safe to Stagnant

If there’s one thing to be learned from “all weather” investment strategies such as muni laddering, it’s this: there is such a thing as too conservative.

If there’s one thing to be learned from “all weather” investment strategies such as muni laddering, it’s this: there is such a thing as too conservative.

Laddering involves building a portfolio of bonds with staggered maturities so that a portion of the portfolio will mature each year. Conservative investors like muni laddering because it’s a passive strategy that allows them to hedge against capital loss or price declines without excessive volatility. It also offers the opportunity to attain better returns than money-market funds in exchange for a small amount of price risk.

But muni laddering may not be the best way to achieve these aims. Indeed, for many it can be an unsound investment strategy, because it is static and not actively managed. Among its other shortcomings:

Muni laddering is biased toward short and intermediate maturities rather than the generally higher-yielding long-term issues. This leaves investors unable to actively manage when and how to invest.

  • It concentrates on bonds with the lowest risk and therefore the lowest returns.
  • It is not focused on after-tax total return.
  • Chances are that an investor who ladders municipal bonds will lose out on investment opportunities and will end up with a long-term return that falls short of what can be obtained by investing in muni bonds using other strategies.

    Hypothetically Speaking…
    In principle a muni ladder is a reasonable strategy. Maturities are staggered so that a 10-year portfolio consists of, say, two-, five-, seven- and 10-year bonds. As the two-year bond matures, the money is reinvested in another 10-year bond, regardless of cost. That maturity-buying rotation is kept going indefinitely. By sacrificing potential capital appreciation, an investor seeks to avoid loss of principal—something many have come to value in the wake of the stock market collapse.

    The problem is that with muni laddering, that’s about all you get. The after-tax total return is limited because the bonds are held to maturity, meaning the ladder is not geared to take advantage of any price appreciation that might occur while the bond is being held.

    Here are more drawbacks:

    Buying and selling opportunities are all but eliminated. The opportunity for investors in muni ladders to take advantage of price depreciation to buy munis is reduced because they are locked into buying and selling at specific times. A ladder also puts an investor—and his advisor—at the mercy of changes in muni-bond rates. Should rates fall, the after-tax total return will fall due to lower income and, with little capital appreciation, the long-term return could suffer. If rates rise, so will the return due to higher income, but you face the possibility of losing out on even greater returns.

    The results of laddering are difficult to measure. There is no benchmark for measuring the performance, so investors have no way of knowing whether returns are good, bad or indifferent.

    Trading costs are relatively high. As each bond matures, trading costs are incurred in buying a new bond in which to invest. Not only do the costs add up because of trading frequency (the maturity-buying rotation again), but municipal bonds tend to be the most expensive bonds, particularly for individual investors to trade because they cannot get the price breaks that large institutional investors do.

    Duration management is eliminated. If an investor believed interest rates were going to increase at a time when one of his muni bonds matured, he likely would buy the longest duration bonds. But at some stage, buying an eight-year bond might make more sense than a 10-year bond. If he is laddering, however, he is forced each time to buy a 10-year bond. Laddering therefore prevents an investor from exercising duration management.

    Sector rotation cannot be implemented. Investors give up sector rotation because they buy the muni bonds and hold them. Should a sector of the market perform well because of market factors, the investor is unable to participate fully in such a rotation.

    Yield is reduced. Muni laddering forfeits the opportunity to obtain a higher yield or higher income, or both, on an investment. The reason: Most of your bond investments in a ladder are concentrated in the short- to medium-term segment of the interest rate curve.

    Issue selection is reduced. Investors are unlikely to be able to search out what could prove to be the best yielding muni bonds. Often better yields come from callable bonds, but muni ladderers cannot have bonds that can be called. If they do and the bonds are called, the ladder collapses. Also investors are unlikely to include muni bonds in a ladder that face even a slight chance of defaulting. As a result, generally investors in muni ladders look for the safest bonds and are therefore forced to buy General Obligation Bonds, which often are not the best performing of the muni bonds and typically provide the lowest income.

    Ability to capitalize on market inefficiencies is reduced. Sometimes inefficiencies occur in the municipal bond market. For example, many investors don’t understand how callable bonds work and so are wary of them. As a result, bonds that are callable pay a higher interest rate than those that are not. But muni-ladder investors cannot capitalize on that higher rate because they cannot have their bonds called away.

    Therefore, advisors should make it clear to their clients that the safety offered by muni laddering comes at an incredibly steep price. Indeed, it’s highly likely the clients would receive better returns using other municipal bond strategies, including investing in funds that specialize in municipal bonds. This will enable investors to match maturity dates to their particular needs. By using funds instead of buying individual securities, an investor avoids trading at typically bad prices given to non-institutional investors and leaves the day-to-day investment decisions to professional money managers who are involved daily with the municipal bond market.

    Mike Ruff is an associate portfolio manager at the Russell Investment Group.

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