**This post was originally published in July of 2024. Given current market valuations, we felt it was timely to revisit the topic in anticipation of better opportunities.**
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?