Does an individual bond ladder offer more protection in a rising rate environment than a bond fund?
Quick Take on Fixed Income
February 2016
Q: Does an individual bond ladder offer more protection in a rising rate environment than a bond fund?
A: Many investors are worried about how rising interest rates will affect their fixed income portfolio. Many believe an individual bond ladder better protects them against rising rates because they can see each bond mature. This is a common misnomer. An environment of rising rates will have a similar effect on the value of an individual bond ladder as it will with a bond fund of similar duration and credit quality. Interest rate risk is measured by duration, which measures the sensitivity of a bond’s price to a change in interest rates. For example, a portfolio with a four-year duration will lose 4 percent of its value if interest rates increase by 1 percent (or vice versa).
We view bond ladders and bond funds as interchangeable investments; both have an indefinite life. We use ladders that are built with the assumption that once the one-year bond matures, the money will be reinvested into the new 10-year bond (or the next rung on the ladder). A bond fund operates the same way. Once a maturity or new money arrives, the fund reinvests at the best point on the curve. No matter if an investor is holding a bond fund or a ladder of individual bonds, both should behave the same assuming the credit quality and duration are equal.
We work with BAM’s Fixed Income department, which views an environment of rising rates as a positive. Rising rates allow investors to reinvest at a new higher rate, increasing the overall yield of the portfolio or fund. The chart below displays a hypothetical yearly 0.50 percent rate increase and how the increase benefits the client. At inception, the federal funds target rate is 0.50 percent.
Assumes a constant four-year duration and an even rate increase across the curve (federal fund rate of 0.50 percent).
The gradual increase in yield across the curve is a positive for the investor. Again, no matter if the portfolio is a bond ladder or a bond fund, it will have similar performance. The only difference in performance — keeping duration and credit quality the same — is the fund’s expense ratio.
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