An Individual Bond Ladder Versus a Bond Fund

Posted by The Dopkins Wealth Team | Mar 15, 2016 8:00:00 PM

Many investors are worried about how rising interest rates will affect their fixed income portfolio. Many bond-ladderbelieve an individual bond ladder better protects them against rising rates because they can see each bond mature. This is a common misnomer. An environment of rising rates will have a similar effect on the value of an individual bond ladder as it will with a bond fund of similar duration and credit quality. Interest rate risk is measured by duration, which measures the sensitivity of a bond’s price to a change in interest rates. For example, a portfolio with a four-year duration will lose 4 percent of its value if interest rates increase by 1 percent (or vice versa).

We view bond ladders and bond funds as interchangeable investments; both have an indefinite life. We use ladders that are built with the assumption that once the one-year bond matures, the money will be reinvested into the new 10-year bond (or the next rung on the ladder). A bond fund operates the same way. Once a maturity or new money arrives, the fund reinvests at the best point on the curve.  No matter if an investor is holding a bond fund or a ladder of individual bonds, both should behave the same assuming the credit quality and duration are equal. 

We work with BAM’s Fixed Income department, which views an environment of rising rates as a positive. Rising rates allow investors to reinvest at a new higher rate, increasing the overall yield of the portfolio or fund. The chart below displays a hypothetical yearly 0.50 percent rate increase and how the increase benefits the client. At inception, the federal funds target rate is 0.50 percent.

 bond_ladder_vs_bond_fund

Assumes a constant four-year duration and an even rate increase across the curve (federal fund rate of 0.50 percent). 

The gradual increase in yield across the curve is a positive for the investor. Again, no matter if the portfolio is a bond ladder or a bond fund, it will have similar performance. The only difference in performance — keeping duration and credit quality the same — is the fund’s expense ratio.

If you still have questions or want to talk about your particular situation, please contact your Dopkins Wealth advisor or anyone on the Dopkins Wealth team.

Related blog

Bond ladders: What they are and what you should know of them

 

Copyright © 2016, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

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Topics: fixed income, bonds; fixed income, bond fund, bond ladder, individual bond ladder

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The Dopkins Wealth Team Dopkins Wealth Management (DWM) is an investment advisory and consulting firm that specializes in providing comprehensive wealth management services by incorporating tax planning, business succession planning, wealth preservation, and wealth transfer into our investment strategies and fiduciary-based solutions. Whether it’s an individual, institutional investor, Corporate 401k plan, foundation or endowment, our clients benefit from our use of an investment strategy grounded in academic research that focuses on long-term success. The key to our client’s success is our ability to understand their unique financial goals and needs, and integrate that with their need, ability, and willingness to take risk to formulate a long-term plan for financial security and prosperity. For more information, contact Tom Emmerling at temmerling@dopkins.com.

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