On top of concerns that the stock market may be highly overvalued right now, investors also have to worry about their bond portfolios.  With interest rates continuing to hover around historic lows, bond investors worry that as rates rise, the value of their bonds will drop.  We painfully experienced this effect last May, when interest rates spiked by 0.75% in one week after the Fed announced it was thinking (only thinking!) of tapering off its quantitative easing program.  Ten year bonds dropped over 7% that month, one of the largest monthly drops in a generation!

I discussed in a blog last August how bond funds might be expected to perform during a period of rising rates (Bond Funds Can Still Do Well When Rates Rise).  But I’ve heard from many readers who remain concerned.  This time I’d like to briefly address the alternative to utilizing bond funds, namely creating individual bond ladders, and explore whether or not that would be a better alternative to bond funds during a rising rate environment.

The advantage of utilizing individual bonds is certainty.  If you purchase a bond and hold it to maturity, you know in advance exactly what the return will be.  That’s not the case with bond funds, which are constantly buying & selling bonds.  Of course, with an individual bond you run the risk that the issuing company goes bankrupt.  But you can avoid that problem by limiting your purchases to bonds with no credit risk, namely U.S. treasury bonds.  (I will not get into a political discussion here about the creditworthiness of the U.S. government.  Consider it a fact that U.S. treasuries are globally accepted to be risk-free.)

If you were to invest the entire fixed income portion of your portfolio into a collection of individual bonds today, you’d find yourself locked into a very low return until all the bonds were to mature.  To avoid that problem, some investors utilize what’s called a ladder: purchasing a series of bonds with overlapping maturities and maintaining that overlap over time.  For example, you could purchase ten U.S. treasury bonds today: one maturing in 2015, another in 2016, the third in 2017, etc. with the last one maturing in ten years (2024).  Each of the bonds would have a different return due to (among other factors) their differing maturities.  When next year rolls around you replace the bond expiring in 2015 with another ten year bond (that is, one maturing in 2025).  Each successive year you do the same.  In this way you will always maintain a portfolio of ten bonds with maturities that vary from one to ten years, with pretty certain guaranteed returns.

Here’s the problem: in today’s low-yield environment, the return is likely to be locked-in at below-inflation yields for at least the next few years.  The portfolio I described above would yield only about 1.5% (not counting trading costs and other fees).  With inflation currently running at 2.1%, you’d be starting out well behind the curve.

You could alternatively create a ladder with longer maturities (by starting with bonds maturing in five to fifteen years, for example).  That would increase the current return.  But you’d be eliminating the ability to reinvest when rates rise for five years.  You could fall significantly behind inflation for quite some time should rates spike during that period.

As another alternative, you could utilize higher yielding corporate bonds instead of treasuries.  Unfortunately, you’d be taking on credit risk for the additional yield, which would reduce the certainty that the bond ladder was intended to provide in the first place.  There’s also the significantly higher trading costs associated with small purchases of commercial bonds, which would further suppress the returns you could get.

Actively-managed bond funds, on the other hand, can access other sources of returns.  Managers can utilize what’s called roll, for example, which takes advantage of the tendency of bond values to increase as they move closer to their maturity date.  In fact, active bond fund managers can utilize information from the yield curve (the difference between yields of treasuries of different maturities) as well as from credit spreads (the difference between higher quality and lower quality bonds) to increase or decrease credit risk or interest rate risk, potentially generating higher yields than a passively maintained bond ladder.  The challenge is finding managers who know how to do this reliably.

Ultimately there is no one right way to maintain a bond portfolio.  But in today’s low interest rate environment, the cost of making mistakes can be a lot higher than when rates are high.  And that’s probably the way it’s going to remain for at least the next couple of decades, so we will all need to get used to it!