Chutes and Bond Ladders

Bond ladders have long been a popular tool for retirement income portfolios. The attraction is the perceived certainty and simplicity of the strategy. The investor has money coming due every year (perhaps starting in the year they expect to retire). This is a “set it and forget it” approach, but there are a couple of important caveats that leave the investor open to tremendous disappointment.

First, the longer maturity bonds could decline significantly in price if long-term interest rates rise, as we believe they likely will. At first glance this may not seem like a problem, but it is our supposition that most investors who take this approach may be shocked to see how much their bonds can drop in value between the date they are purchased and the date they mature. This could lead to emotional decisions to sell them to avoid further paper losses…and the ladder strategy backfires.

The second caveat concerns inflation. If the retiree’s cost of living increases, they may find that they need more income than their bond portfolio can produce. What do they ask their financial advisor to do? “Sell something to raise cash.” The more of their portfolio that is in laddered bonds, the more likely they are to be selling an asset whose value has depleted. Effectively, by using the laddered bond strategy without regard to the current reality of the bond market, the investor has (perhaps unknowingly) created a situation in which their liquidity dries up as bond prices decline. They can get at their money, but only at a greatly impaired value.

Conclusion: at most, a laddered bond approach should be a modest allocation within the total retirement strategy. In our opinion its value is in its emotional comfort to the investor as opposed to the merits of the strategy itself.

© Sungarden Investment Research

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