Are concerns about "bond ladders" valid?

(MoneyWatch) We often hear criticism from the financial media and some professional advisors about the use of "bond ladders." For example, columnist Jane Bryant Quinn took ladders to task in her column "7 Reasons Why Bond Ladders are Bad for Investors." Unfortunately, much of the criticism is based on falsehoods and the conflicts of interests from advisors who only use mutual funds and ETFs. To correct such misperceptions, we'll address each of the criticisms raised, beginning with the issue of credit risk.

Before we get started, here's a quick note about what exactly a bond ladder is. Building a bond ladder involves buying individual bonds with increasingly long maturities. For instance, you might have a ladder than owns bonds that mature each year for the next 10 years. Proceeds from maturities and interest can be used to continue to build the ladder.

It's true that the greatest benefit of mutual funds is diversification, which is critical for investments that have lots of idiosyncratic risks, 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.

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

For example, since 1970 the losses from defaults on bonds of these types has been virtually zero, and that includes a period that spans several recessions and the latest severe financial crisis. We have been buying these types of bonds for our clients for about 15 years and have never experienced a loss from a default. In fact, a ladder of individual bonds of this credit quality will likely have higher quality bonds than that of almost every municipal bond fund, and certainly higher than that of Vanguard's popular funds.

For instance, Vanguard's Intermediate-Term Tax Exempt Fund (VWITX) has about 30 percent of the portfolio invested in credits rated below AA, of which about 9 percent is either below A or unrated. So while VWITX has a more diversified portfolio than would an individual investor holding a bond ladder, the holdings are clearly riskier, requiring that greater diversification.

The argument goes something like this: "Individual investors who trade bonds pay very high costs compared to institutional investors." First, if one is buying Treasury bonds, you can buy them very cheaply directly from the Treasury. And, there are online services where you can check prices, which are highly transparent. Second, with FDIC-insured CDs, there are no costs. However, the point is generally correct if you're an individual buying municipal bonds in the secondary market, though not the primary (new issue) market.

Because these markets are less transparent, individuals buying on their own through broker-dealers can pay large markups, from about 1 percent to as much as 6 percent. Therefore, this practice should be avoided. Individuals buying municipals on their own should limit their purchases to new issues which are sold to all investors at the same price.

However, a registered investment advisor like my firm buys well over a billion dollars a year in bonds, putting broker-dealers into competition with each other. We're able to get the same type of pricing for our clients that the institutional investors like Vanguard get. Markups (dealers are entitled to make some profit) average just 0.1 to 0.2 percent in price, which for a bond ladder with an average maturity of five years would be only about 0.02 to 0.04 percent in yield. In addition, while an institutional investor wouldn't be interested in buying a small lot (such as $25,000 or $50,000), we can buy such bonds and they have the advantage of typically trading at higher yields.

This is a strange criticism since any advisor should be required to provide performance information, whether they buy individual bonds or mutual funds. And there's no reason that information can't be provided. For example, each of our clients receives a quarterly report showing their performance for the quarter, year-to-date and since inception.

Quoting from a recent article by one advisory firm: "Even though it has the appearance of a passive strategy in its strict adherence to buy and hold, it is in reality active because it puts the investor (or her broker/advisor) into the position of a being a bond-picker. Deciding which company's or municipality's bonds to favor at the expense of all the others is vexingly difficult if not impossible for all but seasoned professional bond managers, and even they fall short of passive benchmarks more often than not, according to the Standard and Poors Index vs. Active Funds Scorecard."

This is another canard. The reason is that the highest quality municipal bonds of the same maturity tend to perform virtually identically since there have been virtually no credit losses. For example, a AAA-rated GO bond from some municipality in Missouri will perform virtually identically to another AAA-rated GO bond from a different municipality. The active managers underperform because of their expenses and trading costs, not because they can't pick the right bonds.

It's true that bond funds provide the advantage of conveniently being able to reinvest interest. However, the mistake here is thinking the world is black or white, either all individual bonds or all mutual funds. The owner of an individual bond ladder can also own a bond fund with about the same average maturity as their ladder and move any interest payments to the bond fund until they have sufficient assets to buy another individual bond to extend the ladder. What this also fails to account for is that municipal bond funds themselves typically hold some cash. For example, Morningstar shows that Vanguard's Intermediate-Term Tax-Exempt Fund (VWITX) at last report was holding almost 6 percent of their assets in cash.

The idea behind this is that when "you hold individual bonds and interest rates decline, your bonds will rise in market value. They'll be worth more than you paid for them. But in ladders, you hold to maturity so you'll never collect the capital gains. In a mutual fund, the manager will harvest those gains and add them to the value of your shares." This shows a lack of understanding of bonds. You can't change the nature of the risk of your bonds by the form in which you hold them. A bond fund with an average duration of five years has exactly the same risk profile of a bond ladder with an average duration of five years. The reality is that an interest rate move will cause the portfolio's value to rise (or fall) by the same amount whether your holdings are a fund or a ladder. And if the bond manager harvests a gain, he must then reinvest the money at a now lower rate, leaving the fund in the same position, with the exception of having incurred trading costs.

It's true that a bond fund offers the benefits of liquidity, the ability to sell assets quickly without incurring large costs. However, this again isn't a black and white issue. Investors who build ladders should keep a reserve for liquidity/emergencies. One widely used rule of thumb is to have six months spending needs in a liquid bond fund. However, for obvious reasons, any such fund should have a maturity that is relatively short-term in nature.

Now that we have addressed the criticisms let's move on to point out the many advantages of owning an individually tailored municipal bond ladder/portfolio.

An important benefit of owning individual bonds is avoiding the fees one has to pay a fund manager.

Perhaps the most important benefit of owning individual securities is that investors take 100 percent control over the credit risk and the term risk of their portfolios. They also take control over the timing of cash flows from such a portfolio. This is particularly important to investors relying on their fixed-income assets to provide the cash flow they need to maintain their desired lifestyle. Typically, municipal bond funds own bonds that have call risk (the issuer has the right to prepay the bond). Those bonds carry slightly higher yields to compensate investors for the risk. However, not only does that feature cause investors to lose control over the maturity of their bonds, the reinvestment risk that calls create can show up at the wrong time, when stocks are doing poorly. The issuer will call in the bond, and you now have to reinvest the proceeds at lower rates. That's why I don't recommend buying bonds with calls.

There's another little discussed benefit of owning individual securities. With a mutual fund, after a period of falling interest rates, "hot money" chasing recent performance will typically buy into the fund. The fund, therefore, must buy more bonds in a low-rate environment, lowering the average rate for all investors. Then, if rates begin to rise, the hot money will leave, forcing the fund (and long-term investors in the fund) to suffer capital losses that can't be "waited out." On the other hand, an investor owning individual bonds, who is satisfied with the yield to maturity when the bond was purchased, isn't subject to the same problem. (Other investors can't force him to sell at depressed prices.)

Another advantage of owning individual municipal bonds is that in a rising rate environment the investor has the ability to tax manage (harvest losses) at the individual security level instead of just the fund level.

Another key advantage is the ability to maximize the after-tax return on municipal bonds by tailoring the portfolio to the individual investor's state and tax bracket. For example, the bonds of high-tax states (such as New York and California) tend to trade at lower yields (due to demand from their residents for double tax free interest) than the bonds of no/low-tax states (such as Florida, Nevada and Texas). Unless you're a resident of that particular high tax rate state, there's no reason to own their bonds because you can earn higher after-tax returns purchasing the bonds of low-tax states. Yet, if you own a national municipal bond fund (like those of Vanguard) you're going to own a high percentage of bonds from the high tax states. For example, their Intermediate-Term Tax-Exempt Fund (VWITX) has about 6 percent of their holdings in California bonds and about 5 percent in New York bonds.

Another advantage of a ladder is that you can take advantage of the differences in the shapes of the yield curves between taxable and municipal bonds. Because the municipal bond yield curve is typically steeper than is the Treasury bond curve, there are times when even higher tax bracket investors can benefit from buying taxable bonds or FDIC-insured CDs for the shorter maturities in the ladder and municipals for the longer end.

Finally, bond funds may contain municipal bonds that generate income that is subject to the alternative minimum tax (AMT). They buy those bonds to boost the yield, attracting less knowledgeable investors. These bonds can be avoided when building your own portfolio.

When it comes to investing in stocks, in general, mutual funds provide a major advantage over individual holdings because of the need to diversify the idiosyncratic risks of stocks. However, if investors limit their municipal bond holdings to the highest quality, the only kind I recommend, there's very little need for diversification. Therefore, given the many significant benefits that individual bonds can provide, if you or your advisor has access to institutional pricing and your portfolio is in the area of $1 million or more, you should consider owning individual bonds.

Roll of money image courtesy of taxbrackets.org