At The Money: Building a Bond Ladder with ETFs

How can fixed-income investors create diversified, inexpensive bond ladders using Exchange Traded Funds? Steve Laipply is Global Co-Head of iShares Fixed Income ETFs. Previously, he was Head of U. S. iShares Fixed Income Strategy. He helps to oversee more than a trillion dollars in bond ETFs. Each week, “At the Money” discusses an important topic in money management. From portfolio construction to taxes and cutting down on fees, join Barry Ritholtz to learn the best ways to put your money to work. See omnystudio.com/listener https://omnystudio.com/listener for privacy information.

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• 2:26Barry Ritholtz?

  Investors who are looking for yield, especially in an uncertain rate environment, used to need millions of dollars to build out a bond ladder in a separately managed account. It wasn't easy. There were issues of credit quality, duration, and risk. It made it kind of complex to do. But today, you can create a simple ladder using inexpensive ETFs. I'm Barry Rithelsohn. On today's edition of At the Money, we're going to explain how and when to build your own bond ladder. To help us unpack all of this and what it means for your portfolio, let's bring in Stephen Lapley.

• 3:06Barry Ritholtz?

  He's Managing Director at BlackRock and Global Co-Head of iShares Fixed Income ETFs. Previously, he was Head of U.S. iShares Fixed Income Strategy. He helps to oversee more than $1 trillion in bond ETFs. So Steve, let's start with the basics. What's the problem that a bond ladder is supposed to solve for investors?

• 3:29Speaker 03

  And so I think Barry, this gets to a very popular longstanding practice that advisors and investors have used for years, which is this idea of, you know, I'm not going to be able to really predict the evolution in interest rates. And so what I'm really interested in is cash flows. I'm interested in trying to line up some certainty with income, and I don't really want to take a lot of interest rate risk. So a comfortable thing is to create a ladder, which means you buy some amount of bond exposure in every year, going out to say five years. And if you're worried that interest rates are rising, you could always just not reinvest

• 4:14Speaker 03

  and let that ladder roll down, get your par value back at maturity, and then you could take that cash and go elsewhere. And so that's always been a comfortable thing, this idea that I'm in control. If rates rise, I don't have to worry about a perpetual loss from having an open-ended exposure. I can just let the the bonds roll down and mature and I'm done. That's sort of the idea. Now, in practice, many, many advisors and investors simply roll, okay, over and over again, and just keep putting bonds into that last rung. However, it's just this idea that they have control. And I think that is, that is a very attractive thing. So if you contrast that, for example, with a mutual fund or an SMA or an ETF, you know,

• 4:57Speaker 03

  that may be more of a perpetual open-ended exposure. And then there is a sense that, well, maybe I'm less in control of managing that. So the attractors are ladders, cash flow, you have some certainty and control over, over how it evolves and plays out. And that's, that's why they're so popular.

• 5:14Barry Ritholtz?

  So, so let's delve into that a little bit. And, and for people who are not familiar with the ladder, let's say we're building a seven-year ladder. We're going to have different duration holdings for each of those seven years because we have no idea what rates will be in year three, in year six, in year, however far out you want to go. And so if you're doing a 10-year bond ladder, well, you're only taking a risk with one tenth of that portfolio each year. And when it comes up, you get to decide, do you want to just roll it over to more of the same? Do you want to adjust your credit risk, your duration, even where you're investing? So you're always locking something in. If rates go up, you get to reinvest higher.

• 5:57Barry Ritholtz?

  If rates go down, well, the rest of your portfolio is now worth a little more, but you're going to get a lower yield. Tell us about the products that exist so that you could either do this in, let's call it, seven separate holdings, or just one holding with the ladder built in?

• 6:16Speaker 03

  Yeah, and this is what's fascinating. There are a couple of things to unpack here. So investors can ladder by going out and buying individual bonds, and that's what they've done for many, many years. The downside of that is that depending on the amount you have to work with, you might end up being fairly concentrated if you start out with a smaller amount of proceeds. Because as you know, bond face value is $1,000, and so you may not be able to build out as many holdings per year as you'd like to be diversified. But the advantage of that is, okay, I know each individual bond and I can watch it mature, etc. Another approach would be something that we pioneered back in 2010, which is

• 6:58Speaker 03

  what we call an I-bond, which is meant to be sort of like an individual bond exposure that matures in a given year, but it can hold hundreds of bonds within that year.

• 7:11Barry Ritholtz?

  Fully diversified, in other words.

• 7:13Speaker 03

  So you're diversified tremendously relative to just trying to pick individual bonds for a certain year. So let's say you buy a five-year corporate I-bond. All those bonds will mature in year five, but you may have like upwards of 300 bonds. And so that gives you comfort in terms of the credit risk. Now, the trade-off with that is that it doesn't quite look like an individual bond because you have many bonds. And so your cash flows won't quite be as fixed or certain as they would be by holding an individual bond, but it's roughly the same idea. It's more akin to holding a portfolio of bonds maturing the same year.

• 7:51Barry Ritholtz?

  What are some of the other advantages of building a ladder with ETFs? Clearly, diversification is one. What about pricing, execution, complexity? What are the other advantages?

• 8:02Speaker 03

  And these are the trade-offs. So you have sort of the standard ETF features and benefits. You have exchange transparency. You know the price. You can sell out of it at any time. And again, just to sort of put this into context, imagine if you were holding, you know, a five-year ladder of individual bonds. And let's just say you had the proceeds to build out Pretty diversified portfolio for each year. Imagine trying to sell all those bonds if you decided you needed to raise cash. That would be a non-trivial exercise and it might be quite costly. So with something like an I bond, let's just say you decided to liquidate the entire ladder.

• 8:43Speaker 03

  You get the benefit of the ETF liquidity, just as you would in a traditional investor-grade ETF like LQD or what have you. Now, there are varying degrees of liquidity, of course. Some things may not trade as liquid as others. But the point is, is that that's an ETF feature. The other part of it is just really, really understanding what you own and the ability to trade cheaply relative to individual bonds. So ETFs, you know, trade for bid-esque spreads of pennies on exchange. Individual bonds can be multiples of that, right? So that's, that's sort of the final thing. It's about cost. Of course ETFs have expense ratios. You have to sort of do that trade off, but generally the math is going to work out in your favor.

• 9:24Barry Ritholtz?

  Yeah, the, the cost, the expense ratio, especially for iShares is really quite reasonable. But let's talk about maturity selection. You could build out a ladder almost as far as you want. How should people be thinking about why five years or seven years or 10 years? What goes into that selection process?

• 9:46Speaker 03

  Couple things. So if you look at the tools, for example, we have tools on iShares.com that allow you to build a ladder and it shows you how to build out, you know, to get a certain yield or if you want, you know, a certain duration profile, et cetera. So it really gets down to a couple of things. You know, what sort of overall yield and income profile are you looking for? You know, the other part is what kind of cash flow profile are you looking for? Is there a particular reason that you want to go out to five years or greater? Do you want to be inside of three years because you may want that cash sooner? I mean, let's take a simple example. Let's just say you know you have a life event coming up in three years. You want the last cash flows to be coming due in those three years for sure.

• 10:32Speaker 03

  You can have cash flows coming due past that, but it's far more comfortable to know that you're getting that cash back in year three because you know at that point you're going to take a big trip. You may have college tuition due, et cetera. And so it makes it really easy to think of it in that way. When do I need that cash? Let's just work backwards from there and build it from there.

• 10:52Barry Ritholtz?

  And let's talk a little bit about the tool you have on your website, the iShares Ladder Builder with IBON ETFs. It's really kind of fascinating. You put in a dollar amount, what type of bonds you want, corporate treasury tips, munis, high yield. You could go out as far as 2056. That's amazing, that 30-year bond ladder. And it gives you a whole bunch of different data on this. Are people using this sort of tool to construct their own ETF bond ladders?

• 11:27Speaker 03

  They are. It's proven to be a very popular tool. And that's, you know, that's one of the, I think, interesting and neat things about having these products at your disposal. You know, again, when you're building these ladders, you're getting access to, let's just say you build a pretty robust multi-year ladder, you're effectively buying thousands of bonds, depending on, depending on the sector, let's say corporates. And so that, that would be very, very hard to do. You know, just doing it in individual bond space and it would be more expensive. And so, you know, the tool is, is something that allows you to visualize that and play with it. You can mix different exposures, et cetera. And so I think, I think that's something that, that investors have found to be really, really interesting.

• 12:08Barry Ritholtz?

  Let's talk a little bit about credit quality. I'm old enough to remember when we used to refer to high-yield bonds as junk bonds. If you're putting together a bond ladder, how do you think about juicing the returns a little bit with some high-yield paper?

• 12:24Speaker 03

  And this gets to, I think, you know, investor preference, right? So high yield, by definition, is what it sounds like. However, it comes at a cost, which is you may not get all of that money back because some of it may default. And so that's, that's the rub, right? And so I think investors are going to do, you know, sort of a calculated risk assessment on, on what they're willing to tolerate risk-wise. If you put all of your money into a high-yield ladder, the, the yield will most certainly be higher than investment grade. However, the overall performance may not match that initial yield, right?

• 13:02Speaker 03

  Because over time, you know, some of those, some of those companies may, may default and you may not realize exactly the initial yield you did, it'll be something less. And so that's just, that's just with any high yield bond, right? I think what makes it attractive in the, in the ETF space is that at least you're diversified. And so that's an important point, right? Because if you're trying to do this in individual bond space, you have a lot more risk to those individual companies than if, than if you did it in ETF space.

• 13:33Barry Ritholtz?

  Right. You get to hold so many more individual bonds within the ETF than even a million dollar portfolio is going to be able to do. One of the things that's always interesting is when bonds begin to approach maturity, sometimes the trading is a little counterintuitive. What should investors expect in the final year of any particular bond ETF in their ladder? How, how should they expect this to trade? What happens on maturity?

• 14:01Speaker 03

  Yeah. And this is, I think, something that investors are very, very interested in because with an individual bond, it's pretty easy just to watch. You know, you know, okay, it's one year left, it's three months left, and then on the final day, I'm going to see, you know, the, the thousand dollars hit my account. Bond ETF, what's going to happen is not all those bonds mature on the same day or in the same month. So let's take a full calendar year. You may have some of those bonds start maturing in January. What happens to those? Well, they eventually get reinvested into, you know, cash accounts. In some cases, they may get reinvested in very, very short corporate paper as an example. But ultimately, as bonds keep maturing throughout that year,

• 14:44Speaker 03

  they're all going to be reinvested in cash. And so by the, by the end, you have cash in your account. What will happen, or cash in the, in the bond ETF portfolio, what will then happen is the bond ETF D-list that it gets liquidated, that cash then hits your brokerage account. And that's, that's basically it.

• 15:02Barry Ritholtz?

  So final bond ladder question, what do you think are the biggest mistakes investors tend to make when they build bond ladders? I know I see all the time, people chase yields, they take a little too much credit risk, they don't really think about duration, although I guess you don't have to if it's a fixed year ETF. And then the other risk is the money hits as cash and then it just sits in the account too long. What, what do you see as the biggest problems?

• 15:30Speaker 03

  I think some of it might be the reaching for yield because again, why are you laddering? What are you trying to accomplish? And so I think the best thing to do is always really sit down, figure out what your goals are, and then work backwards. So as an example, at this life event that we were using as an example earlier, let's just say you know you have to have that cash. You have to. Probably not going to want to do a high-yield ladder, right? You may want to do a treasury ladder or a TIPS ladder, inflation-protected ladder. You're probably not going to want to swing for the fences on that one. The other one would be really just trying to understand the reinvestment part of that. What do you do when you get one of the rungs maturing? Do you go out and put it into a longer rung?

• 16:15Speaker 03

  Are you going to take that cash and reinvest it in a money market account? That's investor preference, but it matters for your total return. So that's going to be up to you. But I really do think working backwards from your financial goals is the best way to build a ladder. And then you can do that across the different asset classes. If you can earn more income, by all means, you might want to tilt more towards more credit-intensive assets. Safety is treasuries and TIPS. And so I think that's kind of it.

• 16:43Barry Ritholtz?

  So Steve, some people just like to go out and buy the entire ag, the entire index. What are the differences you see between buying the whole index versus doing ladder?

• 16:54Speaker 03

  Well, you know, Barry, this is really interesting, actually, and it's kind of a math question. But if you look at the behavior of index funds compared to just say, a very simple ladder, where the investor takes the maturing proceeds and goes back out to the longest rung and reinvests, if they just do that over time, over and over and over again, that does not actually look too different than an index fund. It really doesn't. And there has been academic research on this, and we can make it complicated. But the bottom line is perpetual laddering is kind of like indexing. And I think that's sort of fascinating. And so if somebody knows they want to do that, they could also look at an index fund as well. But I always thought that was a really interesting thing if you line them

• 17:39Speaker 03

  up side by side.

• 17:41Barry Ritholtz?

  Huh, that's really, really kind of surprising. I would imagine the latter gives you a little more certainty into what your yield is going to be, whereas the index, you're just, you know, taking wild guess.

• 17:53Speaker 03

  I think that's, I mean, I think both give you some level of certainty. The latter is about control, right?

• 17:57Barry Ritholtz?

  Yes.

• 17:58Speaker 03

  Because you can decide at any time whether to stop reinvesting, and I think that's, that's why they're really popular.

• 18:03Barry Ritholtz?

  Really interesting stuff. So to wrap up, in an uncertain rate environment, investors who have either future financial needs or liabilities that they know can manage around that by using a bond ETF ladder and reinvesting continuously over the cycle of that ladder. I'm Barry Ritholtz. You're listening to Bloomberg's At the Money.

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