Laddered bonds: Are they right for your client?

There was once a time when ladder bond portfolios were all the rage. When interest rates were high, they were a great guaranteed retirement income tool.

You would advise your client to buy, say, five bonds that each matured a year after the other so that the client would have a place to save money and get a guaranteed payout when each fixed-income instrument matured.

With bonds now yielding next to nothing, is the laddered strategy still a good one? The answer, as with most things financial planning-related, is “it depends.”

Beth Hamilton-Keen, Mawer Investment Management’s director of private wealth, says that the laddered strategy can work, but there’s less value in creating a laddered bond portfolio from scratch.

That’s because buying individual bonds can be pricey — some research has shown that a bond purchased from a broker comes with a 2% markup fee.

However, there aren’t many places one can get a set income, so if it’s a guarantee your client is after, then it could still make sense.

“It’s really been about trying to match expenditures with what cash flows will be in the future using various maturities of assets,” says Hamilton-Keene.

Before using this strategy, though, consider these three tips.

Buy A Bond Fund

These days, investors don’t have to create their own laddered bond portfolio. They can simply buy a bond mutual fund or a bond ETF that uses the laddered strategy.

It’s often cheaper — but, as always, be sure to check MERs — and the fund manager is consistently watching how bonds are performing in the portfolio, which is particularly important if you want your client to hold corporates.

Of course, there are trade-offs; the main one being that holding a fund is not as transparent as owning individual bonds, says Hamilton-Keen. You need to find out what kinds of bonds the fund owns and each instrument’s duration.

As well, there are no maturity dates on fund units and they’re more susceptible to interest rate movements. If rates rise, the fund’s price will likely fall — you can’t just hang on and get paid on a certain date.

If your client’s holding bonds for income, then you’ll have to actually remove a set amount of money every year from that fund instead of waiting for the payout that comes with a maturity date, says Gordon Roberts, CIBC professor of financial services at Schulich School of Business.

Still, funds can be a good option. They’re a lot less work, and the cheaper fees may make the risks associated with owning funds worth it.

Don’t Worry About Interest Rate Risk

A lot of people use laddered bonds to blunt the impact of rising interest rates. If something matures in one year, then it won’t fall as much when rates rise as something that matures in, say, a decade.

Short-term laddered bond portfolios, for example, have bonds that mature in one year, two years, three years and so on, so something’s always coming due, says Roberts.

As well, by buying different durations, you’re taking on different interest rate risks, which may be an advantage. (The average duration of your bonds may be three years versus five if you have only five-year bonds.)

Most retirees don’t need to worry too much about interest rate risk, especially if they’re buying individual bonds. The only reason it’s an issue is if it needs to be sold before the maturity date.

If there is an expectation of that happening, then buy a one-year bond, says Hamilton-Keene, as the interest rate difference between a one- and three-year bond isn’t that great. You’ll earn a little less interest, but the bond’s price won’t fall as much.

Ignore Price Fluctuations

Bond prices have soared over the last decade because rates have fallen dramatically, and that’s pushed fixed income prices up.

It’s easy to get swept up in the ups and downs of the bond market, but for income-seeking retirees, it’s critical to keep maturity dates in mind.

That’s especially important now, because when rates rise, bond prices will fall. If people worry more about their bond portfolio dropping, then they may start making bad decisions.

“Bond investing should be about the yield and not about total return,” says Hamilton-Keene. “Over the past 10 years, returns in fixed income have been higher than the yields because rates have come down. That’s not sustainable.”

Consider GICs

You can also create a laddered GIC portfolio, which works the same way as a bond one. In fact, this may be a better option than going the bond route, says Roberts.

Why? In part because GICs are easier to understand. Your clients lend the bank money, the bank pays them interest. Capital won’t fluctuate and global economics won’t impact the investment.

It’s also cheaper, says Roberts. There are no MERs on GICs, but people may have to pay a hefty penalty if they pull their money out of the account early.

These securities are also paying higher rates at the moment. Many financial institutions are offering 5-year GICs with rates of 1% to 2%, while the five-year government of Canada benchmark bond yield is 0.73%.

“In the short term at least, GICs are slightly better for the retail investor,” he says.

Both Roberts and Hamilton-Keene say that laddered bonds still work, but pay close attention to price. Nothing beats the guarantee of maturity dates, but only if you’re not paying a premium to own those individual bonds.