Bond prices have generally been steady, but stock prices often increase and decrease yearly. 2022, however, is shaping up to be a watershed year for fixed income. Bond prices have plummeted because they react inversely to fast-rising interest rates. The iShares Core U.S. Aggregate BondAGG -0.72% exchange-traded fund (ticker: AGG), which tracks a bond index in the United States, has lost 14% year to date.
However, the rise in interest rates has a silver lining: investors now have the opportunity to earn significantly greater returns. The problem is that any future increase in interest rates, as the Fed is signaling, might cause another drop in bond market value, canceling out whatever income you lock in.
Fortunately, a solid strategy to benefit from higher dividends while avoiding interest-rate risk is to construct a bond ladder. Just as it sounds, a bond ladder is a series of fixed-income instruments having staggered maturities. For example, investors who want to take advantage of surprisingly high short-term yields could set up a ladder of Treasuries maturing in one to five years. Roll the principle into a new five-year note when the original bill matures. (This is possible via TreasuryDirect.gov.)
Such a portfolio right now would provide an average yearly yield of slightly over 4%, significantly more appealing than the typical money-market fund. Furthermore, the allure of purchasing Treasuries is that the principal return is assured, and you may reinvest at greater returns if rates increase as projected.
The same clever method can be used for various types of bonds maturing in successive years—and it’s much easier with target-date bond ETFs. These can be set up to provide cash for a needed goal a few years out. For example, have a child heading to college? Set up a ladder with maturity dates staggered to correspond with four years of tuition payments.
To be clear, manually constructing a bond ladder might be difficult for some investors since it involves legwork to discover individual bonds corresponding to appropriate maturity dates. It becomes considerably more difficult if you wish to construct a ladder of corporate, high-yield, or municipal bonds, all of which introduce credit risk into the equation.
Bond ladder ETFs are becoming increasingly popular for investors to simplify their portfolios. In this turbulent market climate, investors value the predictability of set maturity date for investment, says Jason Bloom, Invesco’s director of fixed-income strategy. Net inflows to his firm’s investment-grade bond ladder ETFs already surpassed the previous high of around 40% in 2017. BlackRock’s iShares family of bond ladder ETFs have seen roughly $2 billion in net inflows, far exceeding the $958 million inflows seen in 2021.
Invesco’s Bloom adds that more investors are also utilizing bond ladders within their retirement accounts to line up with expected required minimum distributions, or RMDs, beginning at age 72. Purchasing four or five unique bond ladder ETFs to match subsequent years’ RMDs eliminates the need to sell assets from retirement accounts each year to satisfy an RMD. The mid-December maturity date for funds corresponds quite well with RMD scheduling, Bloom says.
Bond ladders do have certain disadvantages. A laddered plan makes less sense for long-term goals right now because long rates are lower than short rates—an unusual situation in the bond market called an “inverted yield curve,” which generally lasts for a short time. For goals 10 to 15 years in the future, it may make sense to use a short-term ladder now and reinvest the proceeds in longer-term bond ladder funds when those bonds mature.
There are a lot of alternatives. At last count, investors may now choose from among 77 different bond ladder ETFs, which is likely to climb as more investors discover the virtues of these carefully structured investment vehicles.