Seven Reasons Why Advisors Should Use Bond Ladders

I often hear criticisms from the financial media and professional advisors about the use of bond ladders. Whenever the criticism comes from professional advisors, however, I’ve noticed it generally involves firms that use only bond mutual funds or ETFs instead of individual, tailored bond portfolios, whether in the form of a bond ladder or not. Unfortunately, much – if not all – of this criticism is based on falsehoods and the conflicts that can arise when advisors employ only mutual funds and ETFs.

An investor brought to my attention a piece that restated many of the old canards about bond ladders. This article is one of many. Even highly regarded finance columnists like Jane Quinn have taken laddered bond portfolios to task.

To correct the misperceptions, I’ll address each of the criticisms typically raised, beginning with credit risk.

  1. Credit risk and the need for diversification

It’s true that one of the greatest benefits of mutual funds is diversification, which is critical for investments that contain a lot of idiosyncratic risk, like stocks and junk bonds. However, with Treasury bonds and FDIC-insured CDs, there’s no need to diversify, because there isn’t any credit risk.

With corporate bonds, because of the risk of default, there is a need to diversify. Thus, for these assets, mutual funds should be the preferred choice. However, with municipal bonds, if one limits their holdings to AAA/AA and only general obligation (GO) and essential service revenue bonds (the bond types recommended in my book, The Only Guide to a Winning Bond Strategy You’ll Ever Need), the need for diversification is greatly reduced because there is little credit risk (almost all of the risk in these bonds is term risk).

For example, since 1970, losses from default on these types of bonds have been virtually zero, and that includes a period spanning several recessions and the latest severe financial crisis.

In fact, credit quality will be higher (likely significantly higher) through a ladder of individual AAA/AA general obligation or essential service revenue bonds than it will with almost any municipal bond fund, and certainly higher than with popular Vanguard funds.

For example, Vanguard’s Intermediate-Term Tax-Exempt Fund (VWITX) has about 25% of its portfolio invested in credit rated below AA. And about 7% of the bonds held in the fund are either below A or unrated. So, even though VWITX does have a more diversified portfolio than an individual investor holding a bond ladder would, the holdings are also clearly riskier, requiring that greater diversification.

That’s one canard down.