Muni Bond Ladders: An Oversimplified Approach

A Traditional Approach

Municipal bonds are a popular investment option for individual investors. They are primarily sought after for their tax-exempt income and relatively low volatility. One way that investors access the muni market is via laddered portfolios. Muni bond ladders are passive investments that have been used by individual investors for many years. While they are a simple and favored solution, there are many risks to consider.

The Ladder

A bond ladder is a portfolio of individual bonds that are owned directly by the investor. Over the years, investors have warmed to the idea of owning their own bonds. The bond maturities, which represent the rungs of the ladder, are staggered over time. For example, a laddered portfolio might have 20 bonds equally weighted at 5%. In this instance, each maturity is spaced so that one bond matures every six months for 10 years. As the next bond matures, another is purchased with a maturity date that is six months beyond the existing final maturity.

The idea behind the ladder is that investors are content to hold each bond to maturity with the expectation that they will receive par for each bond. Regrettably, any volatility is presumed to be endured rather than seized as an opportunity. Bond ladders are concentrated portfolios of liquid, investment grade (“IG”) bonds that are passively managed. The costs vary, with 20-30bps as a conservative average fee to access such a solution. The laddered approach is an option, but it carries risks that might not be so apparent.

The Risks

Owning a concentrated portfolio of liquid IG bonds sounds safe, until market liquidity dries up. Should liquidity dissipate, IG bonds will become less liquid, and the cost of selling would rise. Even if there is no need to sell, prices in a laddered portfolio could decline. This is because IG bonds are often the first to be sold when investors across the market need to raise cash to reduce risk or meet redemptions. Typically, IG bonds do not adequately compensate investors for the unexpected risks.

If a scenario appears where the muni market comes under stress, and it has, an IG issuer could encounter a problem, and that “rung” could crack. Stress in a bond that makes up 5% of a portfolio will not go unnoticed. Should the stress morph into a broader market problem and spill over into other bonds, another rung could crack. Multiple cracks could impair the laddered portfolio for some time. Why take such a risk?

An Alternative

Despite the popularity of muni bond ladders, CapRidge accesses the market differently. We prefer to invest in national muni bond funds that are run by active managers who use the entirety of the large and complex market to add value and actively manage risk. We want a diversified, liquid and total market strategy that offers our clients more yield for the potential risks that investors often underappreciate. Actively managed national muni bond funds are our alternative to muni bond ladders.