Why Reach For Yield When You Can Use A Ladder?

The current low-interest-rate environment is forcing many investors to reassess their risk tolerances. Typically, fixed-income investors have three main options when trying to “reach” for yield: 1. Move down in credit quality (i.e., take on more credit risk); 2. Increase duration (i.e., take on more interest rate risk); or 3. Move to alternative assets (i.e., those that can potentially incur other illiquidity and lockup provisions). Of course, all of these options pose the same question: Is the incremental yield worth the additional risk?

Staying within the U.S. fixed income asset class, Exhibit 1 shows the broad credit characteristics most investors are currently facing. As expected, a move from BBB investment-grade corporate bonds to BB “junk” bonds produces a 174 bps pick up in yield; however, investors must be willing to tolerate a significant deterioration in credit quality, as well as an exponential increase in default risk. Interestingly, the S&P National AMT-Free Municipal Bond Index has a taxable equivalent yield (TEY) that is 17 bps higher than the yield-to-worst of the S&P U.S. Investment Grade Corporate Bond A Index, offers higher credit quality (AA- versus A), and has a historical default probability of nearly 0%.

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For investors uncomfortable with taking on additional credit risk or interest rate risk, a laddered approach presents an alternative. Bond laddering is a mechanism widely used by the investment community to mitigate the potential risks related to buying individual bonds. A ladder helps smooth out the effect of fluctuations in interest rates because there are bonds maturing every year based on the number of rungs in the ladder. When a bond matures, an investor could reinvest that principal in a new longer-term bond at the end of a ladder. Investors may then benefit from a new, higher interest rate while maintaining the length of the ladder. As shown in Exhibit 2, instead of buying one bond with a six-year maturity, investors can allocate to six different bonds, whereby each bond matures at a different year throughout the six-year horizon.

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