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A “laddered” fixed income portfolio is one built around a series of bonds with staggered maturities. A typical structure might cover a period of ten years, with a rung (i.e. a maturing bond or bonds) for each year. As the shortest rung of the ladder runs off, the proceeds are reinvested into longer-term securities. This seeks to provide consistent income potential and, in a period of rising interest rates, helps migrate the portfolio over time towards higher-yielding assets.
In our view, to maximize the strategy’s effectiveness, cash needs to be reinvested as quickly as possible. The cost of a delay to investors is the difference in the return on cash versus the return on the longer-term bonds. At the moment, cash returns are low or nonexistent, and may be taxable; income potential generated by municipal bonds is generally well above zero and tax advantaged. (As of July 27, 2021, the yield on a 10-year AAA general obligation bond stood at 0.84%. Source: Bloomberg)
As an example, consider a laddered portfolio with a redemption equal to 10% of the value of the holdings. Looking at the market for the last three years, and assuming a two-month timeframe to find an adequate replacement bond, the investor has the potential to lose about -7 bps while sitting in cash. This may not sound like much, but it translates to an annualized loss of -42 bps – a substantial penalty in today’s low interest rate environment. Two redemptions in a year – a drag of -14 bps – has the potential to cost nearly 25% of the starting yield-to-worst (the lowest possible yield, assuming no defaults) for a one-to-ten-year municipal bond ladder.)
Clearly, getting reinvested quickly is important. But there’s a catch: the availability of bonds. While debt issuance at the federal level has been exploding, states and municipalities have been more circumspect. A recent Citibank report noted that state revenues have come in stronger than expected and reduced the need for borrowing. At the same time, demand for tax-advantaged investments has been going up, possibly in reaction to proposed changes to the tax code, among other factors. It’s easy to get crowded out.
Active ETFs offer an alternative
Institutional investors have for many years used exchange-traded funds (ETFs) in lieu of cash as one strategy for what is known as “transition management” – the period when a portfolio is being rebalanced, for example. The same technique can be applied to reduce cash drag in a laddered municipal bond portfolio.
One way to do this is through actively managed municipal ETFs, which provide liquidity, intra-day trading, potentially lower fees, and high transparency. An active manager can make investment decisions based on relative value and can seek to optimize the portfolio to maximize income and total return potential. Risks can be managed through rigorous credit and market analysis. This allows more flexibility as compared to an index-based fund.
For investors employing laddered buy-and-hold strategies, which are passively oriented, we believe an actively managed municipal ETF with intraday liquidity, like the IQ MacKay Municipal Intermediate ETF (MMIT), can add potential alpha while enhancing diversification. MMIT provides low-cost active management without sacrificing the benefits of the ETF structure.
Revisiting the example from earlier, assume again that 10%, or one rung, of a 10-year muni ladder matures. This time, instead of letting the proceeds go to cash, consider the impact of investing them into MMIT. In practice, the historical performance benefit of employing MMIT in conjunction with a laddered muni portfolio is clear. A typical 10-year laddered muni portfolio (as represented by the Bloomberg Barclays Managed Money Short/Intermediate Index) plus a modest allocation of 10% to MMIT, as opposed to 10% cash, has the potential to generate a significant outperformance, adding 54 basis points on an annualized basis.
There may come a day when investors will remember this period of low interest rates fondly – if the Federal Reserve is wrong about the transient nature of the current inflation. In the meantime, investors should work to capture return where possible, while also remaining cognizant of overall risk. For laddered bond holders, a more efficient transition management can be one way to achieve this.
Related: ESG for Bond Funds