A reader asks:
What do you think of iShares – Building Better Bond Ladders with BlackRock to build bond ladders instead of using a bond fund/ETF like BND? How exactly do they work when they mature and send the money back to you based on what you get back? If I buy a $1k ETF, can I get $1k back in the year the ETF matures? Since you can buy/sell whenever you want, it doesn’t seem like the value will remain constant if I buy bonds directly.
There are many target maturity bond funds available now.
Invesco has these. State Street has these bonds. Pioneer too. I’m sure there are others too.
iShares has a tool that allows you to create a bond ladder using these ETFs:
You can switch between different bond types (corporates, treasuries, TIPS, ammunition, and high yield) as you define how far you want to go in terms of maturity. As you switch between different bond types and maturity levels, this changes your yield, maturity, etc. You can see how it will affect you.
It’s pretty nice that you can do this instead of buying individual bonds yourself (which can be tricky if you’ve never done it before).
So why buy bond funds with target maturity?
The reason for these bonds is twofold:
1. You have a specific goal for which you need money at a specific time. If you know you need money for a house down payment within 3 years, you can invest in the 2029 fund. If you know you will pay your child’s college tuition in 5 years, you can purchase a fund with a maturity of 2031.
2. You want to create a vineyard ladder. A bond ladder is a fixed income strategy in which you stagger your portfolio’s maturity dates rather than investing your money in a permanent bond fund or a single security.
Let’s say you have $100,000 to invest.
Instead of investing it all in a single bond or fund, you can create a 5-year bond ladder. You invest $20,000 using funds with maturity dates of 2027, 2028, 2029, 2030, and 2031. It’s called the bond ladder because each maturity level is a step towards a new rung.
Once these bond funds mature, you can use the proceeds for spending purposes or reinvest them in a new 5-year bond.
What is the meaning of the bond ladder?
When you buy a fund like BND it is perpetual, meaning the fund never fully matures. Currently, the average maturity of BND is around 8 years and the average duration is around 5.7 years.
These figures may vary slightly because the types of bonds in the fund may change over time. But the maturity of a permanent bond fund like this never approaches zero, unlike an individual bond or ETFs with target maturity.
Bond managers sell securities in the fund and purchase new ones as they mature, keeping the average duration/maturity relatively consistent.
If rates rise, the value of a fund like BND may fall and take some time to recover. Even with income included, BND has a modest decline when rates rise in 2022:
In a recession environment, you would expect to see the opposite, with rates falling and this fund increasing your portfolio. You won’t get much of a lift on the bond ladder unless you sell the funds, which defeats the purpose.
Basic target maturity funds will still see some movement in price as variables such as interest rates, inflation and economic growth change. However, as we approach maturity, volatility decreases. Regardless of market conditions, price sensitivity decreases as equal pay becomes more predictable.
And yes, assuming there are no defaults along the way, you should receive more or less par value at maturity.
A bond ladder can be helpful when it comes to interest rate risk, as you’ll be diversifying your entry points across different rate levels. In many ways, a bond ladder is a form of dollar-cost averaging across different yields and maturities.
But there is reinvestment risk If you reinvest proceeds from a maturing fund and current returns are lower.
A bond ladder can make sense for any investor who wants stable, predictable cash flow without trying to focus on a single point on the yield curve.
There is also more maintenance involved with a vineyard ladder. You have to reinvest in maturing bonds, determine how far down the maturity spectrum you want to go, choose the types of bonds you want to invest in, etc. must.
It’s a little more complicated.
If you need money at a specific time or like the convenience of knowing when your bonds mature, a bond ladder may make sense. Many retirees like the bond ladder for peace of mind.
If you prefer more general fixed income exposure with less active management, something like BND or another bond fund would make more sense.
One option is not better or worse than the other. Each has its pros and cons.
I answered this question on this week’s new Compound Ask:
We also answered audience questions about the CAPE ratio, international diversification, how to overcome financial anxiety, and paying for an actively managed portfolio.
Further Reading:
Individual Bonds and Bond Funds
