Understanding Municipal Bond Ladders in a Rising Rate Environment

An attractive approach for investors seeking tax-efficient income and capital preservation

In a laddered portfolio, maturing bonds and coupon payments are typically reinvested in bonds at the ladder’s longest rung, which usually offers higher yields. This can be an advantage in a rising interest rate environment.

What is a bond ladder?
A ladder is a portfolio of bonds that mature at regular intervals (often every year or every other year) across a chosen maturity range. As a bond matures, principal is typically reinvested in the rung of the ladder having the longest maturity. This approach seeks to generate a more predictable income stream; it may also provide an advantage in a rising rate environment, since periodically maturing proceeds are reinvested at potentially higher rates. Laddered portfolios composed of municipal bonds can be an attractive investment for investors seeking relatively stable tax-efficient income and capital preservation.

Why ladders in the current lower yielding environment?
Even if interest rates don’t rise much further, the yield of an existing ladder may move higher over time – a potential benefit that many investors overlook. Once a ladder is in place, the rungs of the ladder only need to be replaced when bonds mature. Consider that as bonds “roll down” the ladder over time, a two-year bond will become a one-year bond, a three-year bond will become a two-year bond, etc. Thus, as time passes, each rung will typically be filled except for the longest maturity, where reinvestment will be focused as shown in Figure 1. Therefore, even if the municipal yield curve remains relatively unchanged, the portfolio’s average purchase yield* should converge toward the yield of the longest maturity bond in the laddered portfolio and the tax-efficient income stream will thus increase over time.

*The average purchase yield of a portfolio is the weighted average yield to maturity of the securities in the portfolio at the time of investment.

Why put money to work now when interest rates may rise further?
There is an opportunity cost to sitting in zero-yielding cash. Moreover, forecasting interest rate movements is difficult even for the most skilled fixed income investor. By investing across a range (or ladder) of maturities, laddered portfolios reduce the need to perfectly “time” interest rates. The longer rungs of the ladder bring the average yield of the portfolio higher and protect against the possibility that we remain in a low yield environment for longer than anticipated. Meanwhile, having shorter and regularly maturing bonds helps ensure that if and when rates do rise further, there are opportunities to capture higher yields without liquidating existing holdings at a loss.

Won’t a bond portfolio lose money as rates rise?
Rising yields do typically mean falling bond prices. However, PIMCO’s laddered strategies intend to hold bonds to maturity and let them mature at par. Thus, any price volatility due to rising rates will not affect the original yield at purchase, but may bring the average yield of the portfolio higher over time. Since rising rates provide the opportunity to reinvest proceeds from maturing bonds and coupon payments at a higher yield, rising rates are actually a good thing for a bond ladder investor. The result may be higher income as shown in the example in Figure 2.

Why hire an active manager like PIMCO to build a bond ladder?
The municipal market has approximately 80,000 issuers, and the decline of bond insurance post-crisis has made credit analysis essential. Rigorous fundamental credit research drives the municipal bond selection process for our ladder strategies, and our analysts develop their own internal ratings independent of the rating agencies. We monitor the quality of every credit we purchase on an ongoing and forward-looking basis, helping guard portfolios from the adverse price and liquidity impacts of a negative credit event.

Additionally, because PIMCO manages $40 billion+ in municipal assets (AUM as of December 31, 2015), we may be able to provide economies of scale in price and transaction costs that are passed on to investors. As shown in Figure 3, buying in larger blocks before allocating across individual accounts can reduce transaction costs for individuals, leading to better execution and the potential for higher yields.

Lastly, PIMCO’s institutional market presence results in access to a broad universe of municipal inventory and primary supply. This helps us navigate the supply and demand dynamics that are particularly important in a retail-driven market and often allows us to quickly take advantage of dislocations to seek out attractive risk-adjusted offerings.

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A Word About Risk: Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

Individuals should consult with their own financial advisors to determine the most appropriate allocations for their financial situation, including their investment objectives, time frame, risk tolerance, savings and other investments.

This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2016 PIMCO