Bond ladders are often touted as a simple, effective, and inexpensive means of diversifying the bond portion of an investment portfolio. While simplicity can be a virtue, it doesn’t necessarily translate into effective and inexpensive. For example, there are “hidden” premiums that a retail investor pays when purchasing individual bonds to construct a ladder that go beyond the commission paid to the broker/advisor. The most liquid issues, those most likely to be available to the retail investor, also generally command a premium for their liquidity, reducing the potential return available to the investor. Additionally, bid/ask spreads are greater on smaller lots. In the bond market, this generally means orders less than $100,000 for one specific security. The implication of this is that individual or small lot bond purchases cost considerably more, and by reducing the effective return, the investor is paying for the premiums throughout the life of the ladder. Should any of the bonds need to be liquidated prior to maturity, the greater spread penalizes the investor a second time.

Because of the risk that a credit downgrade or default of even a single issue brings to the investor of less than $100,000 in a bond ladder, a passive ladder usually only invests in the highest quality bonds. The opportunity costs of avoiding alternative, lower quality but higher yielding bonds could be substantial. The greatest, and simplest, risk in a bond ladder is to the value of the individual issues should interest rates rise. Of course, this particularly affects the longer duration bonds. While many will point out that bonds have been increasing in value the past several years, the two decade drop in long term interest rates (from a high of about 16% in 1982) driving the bond bull market has only occurred this one time in the past 80 years. Given that it’s been practically 40 years since long term rates have been as low as they are today, there appears to be significantly more risk from rates rising than opportunity from them falling. For example, a hypothetical 30 year bond priced at 100 with a 5% coupon can lose approximately 14% of its value should 30 year interest rates rise only 1%, all other factors remaining equal. An interest rate rise of 2% translates into an equivalent 25% loss of value! While the client will still receive his expected coupon, the value and purchasing power of that coupon will be less should inflation track with the interest increase. And if they should need to liquidate any of their holdings for unexpected needs, the principal can be considerably less than that invested. This is not the way to retain clients.

Bond funds offset some of the disadvantages of a ladder, but can have several of their own. They provide greater diversification, such that default risk is rarely a significant issue (excepting high yield). Additionally, they purchase their securities at institutional volumes, minimizing both bid/ask spreads and transaction costs, thereby reducing the oft mentioned effect of their own internal management expenses. As passive investments, however, bond funds present the diligent advisor with several challenges. Most funds cover a particular sector or duration, and determining which is appropriate at any given point in time is vital, as interest rate change affects bond funds as it does individual bonds. And broad definitions are not always useful, as short, intermediate, and long term carry different meaning to different managers. Additionally, different managers employ different bond investment strategies, and some are better than others, or better in certain market conditions. Determining which fund manager is most appropriate for a given market condition, and closely following both the market and the appropriate funds, is a responsibility of the investment advisor. BTS’ Select Bond Asset Allocation (BAA) strategy provides several potential advantages for investment advisors and their clients over investing directly in bond ladders or passively in bond funds. Unlike a bond ladder, BAA utilizes BTS’ timetested, proprietary trend models to select the bond asset class most appropriate for given market conditions, positioning between long term government bonds, high yield bonds, and money market. Since the advent of Select BAA, BTS has the opportunity to select top performing funds for those conditions, switching between funds within asset classes, and even diversifying among both asset classes and funds as appropriate. As an additional option for the client, BTS can include a high yield inverse fund in the strategy for use when warranted. In the Select BAA strategy, BTS can actively diversify among bonds, bond classes, and bond funds, while actively managing the risks inherent in each given constantly changing market condition.