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At The Money: Building a Bond Ladder with ETFs · Masters in Business

• 0:02
  Speaker 1: Bloomberg Audio Studios, podcasts, radio news.
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  Speaker 2: Investors who are looking for yield, especially in an uncertain
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  Speaker 2: rate environment, used to need millions of dollars to build
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  Speaker 2: out a bond ladder in a separately managed account. It
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  Speaker 2: wasn't easy. There were issues of credit quality, duration and risk.
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  Speaker 2: It made it kind of complex to do. But today
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  Speaker 2: you can create a simple ladder using inexpensive ETFs. I'm
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  Speaker 2: Barry Ridoltson on today's edition of At the Money. We're
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  Speaker 2: going to explain how and when to build your own
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  Speaker 2: bond ladder to help us unpack all of this and
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  Speaker 2: what it means for your portfolio. Let's bring in Stephen Lately.
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  Speaker 2: He's Managing director at Blackrock and Global co head of
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  Speaker 2: I Shares Fixed Income ETFs. Previously he was head of
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  Speaker 2: US I Shares Fixed Income Strategy. He helps to oversee
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  Speaker 2: more than a trillion dollars in bond ETFs. So Steve,
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  Speaker 2: let's start with the basics. What's the problem that a
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  Speaker 2: bond ladder is supposed to solve for investors?
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  Speaker 3: And so I think Barry, this gets to a very popular,
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  Speaker 3: long standing practice that advisors and investors have used for years,
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  Speaker 3: which is this idea of you know, I'm not going
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  Speaker 3: to be able to really predict the evolution and interest rates,
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  Speaker 3: and so what I'm really interested in is cash flows.
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  Speaker 3: I'm interested in trying to line up some certainty with income,
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  Speaker 3: and I don't really want to take a lot of
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  Speaker 3: interest rate risks. So a comfortable thing is to create
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  Speaker 3: a ladder, which means you buy some amount of bond
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  Speaker 3: exposure in every year going out to say five years,
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  Speaker 3: and if you're worried then interest rates are rising, you
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  Speaker 3: can always just not reinvest and let that ladder roll down,
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  Speaker 3: get your par value back at maturity, and then you
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  Speaker 3: could take that cash and go elsewhere. And so that's
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  Speaker 3: always been a comfortable thing, this idea that I'm in control.
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  Speaker 3: If rates rise, I don't have to worry about a
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  Speaker 3: perpetual loss from having an open ended exposure. I can
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  Speaker 3: just let the bonds roll down and mature and I'm done.
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  Speaker 3: That's sort of the idea. Now in practice, many many
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  Speaker 3: advisors and investors simply roll okay over and over again
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  Speaker 3: and just keep putting bonds into that last rung. However,
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  Speaker 3: it's just this idea that they have control, and I
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  Speaker 3: think that is that is a very attractive thing. So
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  Speaker 3: if you could trust that, for example, with a mutual
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  Speaker 3: fund or an SMA or an ETF, you know that
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  Speaker 3: may be more of a perpetual, open ended exposure, and
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  Speaker 3: then there is a sense that, well, maybe I'm less
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  Speaker 3: in control of managing that. So the attractive or ladder
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  Speaker 3: is cash flow. You have some certainty in control over
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  Speaker 3: over how it evolves and plays out, and that's why
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  Speaker 3: they're so popular.
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  Speaker 2: So let's delve into that a little bit. And for
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  Speaker 2: people who are not familiar with the ladder, let's say
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  Speaker 2: we're building a seven year ladder. We're going to have
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  Speaker 2: different duration holdings for each of those seven years because
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  Speaker 2: we have no idea what rates will be in year three,
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  Speaker 2: in year six, and year however far out you want
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  Speaker 2: to go. And so if you're doing a ten year
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  Speaker 2: bond ladder, well, you're only taking a risk with one
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  Speaker 2: tenth of that portfolio each year, and when it comes up,
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  Speaker 2: you get to decide do you want to just roll
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  Speaker 2: it over to more of the same do you want
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  Speaker 2: to adjust your credit risk your duration even where you're investing,
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  Speaker 2: so you're always locking something in if rates go up,
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  Speaker 2: you get to reinvest higher. If rates go down, Well,
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  Speaker 2: the rest of your portfolio is now worth a little more,
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  Speaker 2: but you're going to get a lower yield. Tell us
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  Speaker 2: about the products that exist, so that you could either
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  Speaker 2: do this in let's call it seven separate holdings or
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  Speaker 2: just one holding with the ladder built in.
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  Speaker 3: Yeah, and this is this is what's fascinating. There are
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  Speaker 3: a couple things do unpack here. So investors can ladder
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  Speaker 3: by going out and buying individual bonds, and that's what
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  Speaker 3: they've done for many, many years. The downside of that
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  Speaker 3: is that, depending on the amount you have to work with,
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  Speaker 3: you might end up being fairly concentrated if you start
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  Speaker 3: out with a smaller amount of proceeds because as you know,
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  Speaker 3: you know, bond face value is one thousand dollars, and
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  Speaker 3: so you may not be able to build out as
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  Speaker 3: mini holdings.
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  Speaker 4: Per year as you'd like to be diversified.
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  Speaker 3: But the advantage of that is, Okay, I know each
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  Speaker 3: individual bond and I can watch it mature, et cetera.
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  Speaker 3: Another approach would be something that we pioneer back in
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  Speaker 3: twenty ten, which is what we call an I bond,
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  Speaker 3: which is meant to be sort of like an individual
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  Speaker 3: bond exposure that mature is in a given year, butt
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  Speaker 3: it can hold hundreds of bonds within that year.
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  Speaker 2: Right, So fully diversified another, So.
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  Speaker 3: You're diversified tremendously relative to just trying to pick individual
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  Speaker 3: bonds for a certain year. So let's say you buy
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  Speaker 3: a five year corporate eebond. All those bonds will mature
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  Speaker 3: in year five, but you may have like upwards of
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  Speaker 3: three hundred bonds, and so that gives you comfort in
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  Speaker 3: terms of the credit risk. Now, the trade off with
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  Speaker 3: that is that it doesn't quite look like an individual
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  Speaker 3: bond because you have mini bonds, and so your cash
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  Speaker 3: flows won't quite be as fixed or certain as they
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  Speaker 3: would be by holding an individual bond.
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  Speaker 4: But it's roughly the same idea.
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  Speaker 3: It's more kin to holding a portfolio of bonds maturing
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  Speaker 3: the same year.
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  Speaker 2: What are some of the other advantages of building a
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  Speaker 2: ladder with ETFs? Clearly diversification is one. What about pricing,
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  Speaker 2: execution complexity? What are the other advantages?
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  Speaker 4: And these are the trade offs.
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  Speaker 3: So you have sort of the standard ETF features and benefits.
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  Speaker 3: You have exchange transparency, you know the price, you can
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  Speaker 3: sell out of it at any time. And again just
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  Speaker 3: to sort of put this into context, imagine if you
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  Speaker 3: were holding, you know, a five year ladder of individual bonds,
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  Speaker 3: and let's just say you had the proceeds to build
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  Speaker 3: out a pretty diversified portfolio for each year. Imagine trying
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  Speaker 3: to sell all those bonds if you decided you needed
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  Speaker 3: to raise cash, that would be a non trivial exercise,
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  Speaker 3: and it might be quite costly. So with something like
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  Speaker 3: an eyebond, let's just say you decided to liquidate the
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  Speaker 3: entire ladder, you get the benefit of the ETF liquidity,
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  Speaker 3: just as you would in a traditional investment grade ETF
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  Speaker 3: like LQD or what have you. Now, there are varying
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  Speaker 3: degrees of liquidity. Of course, some things may not trade
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  Speaker 3: as liquid as others. But the point is is that
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  Speaker 3: that's an ETF feature. The other part of it is
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  Speaker 3: just really really understanding what you own and the ability
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  Speaker 3: to trade cheaply relative to individual bonds. So ets, you know,
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  Speaker 3: trade for bid esque spreads of pennies on exchange. Individual
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  Speaker 3: bonds can be multiples of that, right, So that's that's
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  Speaker 3: sort of the final thing.
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  Speaker 4: It's about cost.
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  Speaker 3: Of course, ETFs have expense ratio, so you have to
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  Speaker 3: sort of do that trade off, but generally the math
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  Speaker 3: is going to work out in your favor.
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  Speaker 2: Yeah, the cost, the expense ratio, especially for I shares
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  Speaker 2: is really quite reasonable. But let's talk about maturity selection.
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  Speaker 2: You could build out a ladder almost as far as
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  Speaker 2: you want. How should people be thinking about why five
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  Speaker 2: years or seven years or ten years? What goes into
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  Speaker 2: that selection process?
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  Speaker 4: Couple things.
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  Speaker 3: So if you look at the tools, For example, we
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  Speaker 3: have tools on i shares dot com that allow you
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  Speaker 3: to build a ladder and it shows you how to
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  Speaker 3: build out, you know, to get a certain yield or
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  Speaker 3: if you want, you know, a certain duration profile, et cetera.
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  Speaker 3: So it really gets down to a couple of things.
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  Speaker 3: You know, what sort of overall yield and income profile
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  Speaker 3: are you looking for?
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  Speaker 1: You know?
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  Speaker 4: The other part is what kind of cash flow profile
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  Speaker 4: are you looking for?
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  Speaker 3: Is there a particular reason that you want to go
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  Speaker 3: out to five years or greater? Do you want to
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  Speaker 3: be inside of three years because you may want that
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  Speaker 3: cash sooner. I mean, let's take a simple example. Let's
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  Speaker 3: just say you know you have a life event coming
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  Speaker 3: up in three years. You want the last cash flows
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  Speaker 3: to be coming doing those three years, for sure, you
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  Speaker 3: can have cash flows coming do past that, but it's
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  Speaker 3: far more comfortable to know that you're getting that cash
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  Speaker 3: back in year three because you know at that point
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  Speaker 3: you're going to take a big trip, you may have
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  Speaker 3: college tuition, do et cetera. And so it makes it
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  Speaker 3: really easy to think of it in that way, when
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  Speaker 3: do I need that cash? Let's just work backwards from
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  Speaker 3: there and build it from there.
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  Speaker 2: And let's talk a little bit about the tool you
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  Speaker 2: have on your website, the I shares Ladder builder with
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  Speaker 2: ivan ETF. It's really kind of fascinating. You put in
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  Speaker 2: a dollar amount what type of bonds you want, Corporate Treasury, tips, munis,
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  Speaker 2: high yield, you could go out as far as twenty
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  Speaker 2: fifty six. That's amazing, that thirty year bond ladder, and
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  Speaker 2: it gives you a whole bunch of different data on this.
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  Speaker 2: Are people using this sort of tool to construct their
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  Speaker 2: own ETF bond ladders? They are.
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  Speaker 3: It's proven to be a very popular tool, and that's,
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  Speaker 3: you know, that's one of the I think interesting and
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  Speaker 3: neat things about having these products at your disposal. You know, again,
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  Speaker 3: when you're building these ladders, you're getting access to let's
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  Speaker 3: just say you build a pretty robust multi year ladder.
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  Speaker 3: You're effectively buying thousands of bonds depending on depending on
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  Speaker 3: the sector, let's say corporates, and so that that would
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  Speaker 3: be very very hard to do, you know, just doing
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  Speaker 3: an individual bond space, and it would be more expensive.
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  Speaker 3: And so you know, the tool is something that allows
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  Speaker 3: you to visualize that and play with it. You can
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  Speaker 3: mix different exposures, et cetera. And so I think I
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  Speaker 3: think that's something that that investors have found to be
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  Speaker 3: really really interesting.
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  Speaker 2: Let's talk a little bit about credit quality. I'm old
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  Speaker 2: enough to remember when we used to refer to high
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  Speaker 2: yield bonds as junk bonds. If you're putting together a
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  Speaker 2: bond ladder, how do you think about juicing the returns
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  Speaker 2: a little bit with some high yield paper?
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  Speaker 3: And this gets to I think, you know, investor preference, right,
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  Speaker 3: So high yield by definition is what it sounds like. However,
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  Speaker 3: it comes at a cost, which is you may not
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  Speaker 3: get all of that money back because some of it
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  Speaker 3: may default. And so that's that's the rub, right, And
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  Speaker 3: so I think investors are going to do, you know,
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  Speaker 3: sort of a calculated risk assessment on what they're willing
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  Speaker 3: to tolerate. Risk Wise, if you put all of your
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  Speaker 3: money into a high yield ladder, the yield will most
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  Speaker 3: certainly be higher than investment grade. However, the overall performance
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  Speaker 3: may not match that initial yield, right because over time,
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  Speaker 3: you know, some of those some of those companies may
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  Speaker 3: may default and you may not realize exactly the initial
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  Speaker 3: yield you did. It'll be something less. And so that's
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  Speaker 3: just that's just with any high you'll bond, right. I
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  Speaker 3: think what makes it attractive in the in the ETF
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  Speaker 3: space is that at least you're diversified. And so that's
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  Speaker 3: an important point, right, because if you're trying to do
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  Speaker 3: this in individual bond space, you have a lot more
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  Speaker 3: risk to those individual companies. And if than if you
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  Speaker 3: did in an ETF space.
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  Speaker 2: Right, you get to hold so many more individual bonds
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  Speaker 2: within the ETF than even a million dollar portfolio was
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  Speaker 2: going to be able to do. One of the things
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  Speaker 2: that's always interesting is when bonds begin to approach maturity,
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  Speaker 2: sometimes the trading is a little counterintuitive. What should investors
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  Speaker 2: expect in the final year of any particular bond ETF
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  Speaker 2: in their ladder? How should they expect this to trade?
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  Speaker 2: What happens on maturity.
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  Speaker 3: Yeah, and this is I think something that investors are
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  Speaker 3: very very interested in because with an individual bond, it's
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  Speaker 3: pretty easy just to watch, you know, you know, okay,
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  Speaker 3: it's one year left, it's three months left, and then
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  Speaker 3: on the final day, I'm going to see, you know,
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  Speaker 3: the thousand dollars hit in my account, bondie TF What's
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  Speaker 3: going to happen is not all those bonds mature on
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  Speaker 3: the same day or in the same month. So let's
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  Speaker 3: take a full calendar year. You may have some of
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  Speaker 3: those bonds start maturing in January. What happens to those well,
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  Speaker 3: they eventually get reinvested into you know, cash accounts. In
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  Speaker 3: some cases they may get reinvested in very very short
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  Speaker 3: corporate paper as an example. But ultimately, as bonds keep
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  Speaker 3: maturing throughout that year, they're all going to be reinvested
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  Speaker 3: in cash. And so by the by the end you
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  Speaker 3: have cash in your account, what will happen or cash
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  Speaker 3: in the in the BONDI TIA portfolio. What will then
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  Speaker 3: happen is the BONDI TFD lists that it gets liquidated.
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  Speaker 3: That cash then hits your brokerage account. And that's that's basic.
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  Speaker 2: So final bond ladder question, What do you think are
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  Speaker 2: the biggest mistakes investors tend to make when they build
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  Speaker 2: bond ladders. I know I see all the time people
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  Speaker 2: chase yield. They take a little too much credit risk,
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  Speaker 2: They don't really think about duration, although I guess you
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  Speaker 2: don't have to if it's a fixed year ETF. And
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  Speaker 2: then the other risk is the money hits his cash
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  Speaker 2: and then it just sits in the account too long.
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  Speaker 2: What do you see as the biggest problems.
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  Speaker 3: I think some of it might be the reaching for yield,
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  Speaker 3: because because again, why are you laddering? What are you
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  Speaker 3: trying to accomplish? And so I think the best thing
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  Speaker 3: to do is always really sit down, figure out what
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  Speaker 3: your goals are, and then work backwards. So as an
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  Speaker 3: example at this life event that we were using as
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  Speaker 3: an example earlier, let's just say, you.
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  Speaker 4: Know, you have to have that cash.
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  Speaker 3: You have to probably not going to want to do
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  Speaker 3: a high yield ladder, right You may want to do
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  Speaker 3: a treasury ladder or a tips ladder, inflation protected ladder.
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  Speaker 3: You're probably not going to want to swing for the
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  Speaker 3: fences on that one. The other one would be really
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  Speaker 3: just trying to understand the reinvestment.
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  Speaker 4: Part of that.
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  Speaker 3: What do you do when you get one of the
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  Speaker 3: rungs maturing. Do you go out and put it into
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  Speaker 3: a longer rung? Are you going to take that cash
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  Speaker 3: and reinvest in a money market account. That's investor preference,
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  Speaker 3: but it matters for your total returns, So that's going
• 14:22
  Speaker 3: to be up to you. But I really do think
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  Speaker 3: working backwards from your financial goals is the best way
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  Speaker 3: to build a ladder, and then you can do that
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  Speaker 3: across the different asset classes. If you can earn more
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  Speaker 3: income by all means, you might want to tilt more
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  Speaker 3: towards more credit intensive assets. Safety is treasuries and tips,
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  Speaker 3: and so I think that's kind of it.
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  Speaker 2: So, Steve, some people just like to go out and
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  Speaker 2: buy the entire ag the entire index. What are the
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  Speaker 2: differences you see between buying the whole index versus doing
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  Speaker 2: the ladder?
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  Speaker 3: Well, you know, Barry, this is really interesting, actually, and
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  Speaker 3: it's kind of a math question. But if you look
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  Speaker 3: at the behavior of index funds compared to just say
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  Speaker 3: a very simple ladder where the investor takes the maturing
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  Speaker 3: proceeds and goes back out to the longest rung and reinvest.
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  Speaker 3: If they just do that over time, over and over
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  Speaker 3: and over again, that does not actually look too different
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  Speaker 3: than an index fund.
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  Speaker 4: It really doesn't.
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  Speaker 3: And there has been academic research on this, and we
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  Speaker 3: can make it complicated, but the bottom line is perpetual
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  Speaker 3: laddering is kind of like indexing, and I think that's
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  Speaker 3: sort of fascinating. And so if somebody knows they want
• 15:32
  Speaker 3: to do that, they could also look at an index
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  Speaker 3: fund as well. But I always thought that was a
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  Speaker 3: really interesting thing. If you line them up side by side.
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  Speaker 2: Huh, that's really really kind of surprising. I would imagine
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  Speaker 2: the ladder gives you a little more certainty into what
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  Speaker 2: your yield is going to be, whereas the index you're
• 15:49
  Speaker 2: just you know, taking wild guests.
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  Speaker 3: I think that's I mean, I think both give you
• 15:54
  Speaker 3: some level certain The ladder is about control, right, yes,
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  Speaker 3: because you can decide in any time whether to stop reinvesting.
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  Speaker 4: And think that's why they're really.
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  Speaker 2: Popular, really interesting stuff. So to wrap up in an
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  Speaker 2: uncertain rate environment, investors who have either future financial needs
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  Speaker 2: or liabilities that they know can manage around that by
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  Speaker 2: using a bond etf ladder and reinvesting continuously over the
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  Speaker 2: cycle of that ladder. I'm Barry Ridults. You're listening to
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  Speaker 2: Bloomberg's at the mone