A recent Morningstar article outlines the pros and cons of bond laddering—holding bonds of different maturities in a portfolio with the goal of creating predictable streams of cash flow.
- The current interest-rate environment “doesn’t much matter to you if you’ll get your bond’s face value back at maturity.”
- Investors don’t need to worry about incurring capital losses by selling their bonds for a discount in a rising-rate environment because they’ll holding the bond to maturity.
- Default risk: The article explains that the success of a bond laddering strategy is “contingent on the bonds supplying your cash flows not defaulting—and this is no minor risk. This is why you should build a bond ladder with stable, high-quality, noncallable bonds.”
- Research complexity: Professional bond fund managers “go beyond bond ratings issued by credit ratings agencies” and have expertise the average individual investor may not.
- Diversification risk: Given that bonds are typically issued with face values of $1000, individual-bond buyers can have difficulty building a well-diversified portfolio without “a ton of money.”
- High trading costs: “Even investors who are buying many thousands of dollars’ worth of bonds may face much higher bid-ask spreads than institutional buyers who are trading millions might pay.”
The article concludes that the best approach to bond laddering involves focusing on “stable, high-quality, noncallable bonds instead of those with the highest yields.” Another option, it says, is “defined-maturity bond mutual funds and exchange-traded funds” which combine characteristics of individual bonds with diversification of bond mutual fund portfolios.