Understanding Municipal Bond Ladders in a Rising Rate Environment
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 six months or every year) across a chosen maturity range. As a bond matures, principal is typically reinvested in the rung of the ladder with the longest maturity. This approach seeks to generate a predictable income stream; it may also provide an advantage in a rising rate environment, since periodically maturing proceeds are reinvested at higher yields if market rates rise. Additionally, laddered portfolios composed of municipal bonds can be an attractive investment for investors seeking relatively stable tax-efficient income and capital preservation.
Why consider ladders in the current lower yielding environment?
In the current low yield environment, investors may be understandably concerned about how their municipal investments will perform if rates rise, and whether they will be positioned to take advantage of rising rates. Fortunately, ladders may help ease these concerns: mitigating downside by investing based on a hold-to-maturity philosophy and capturing some of the potential upside by consistently reinvesting into the longest rung of the ladder.
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. 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, over time the portfolio’s average purchase yield* should converge toward the yield of the longest maturity bond in the laddered portfolio – this the tax-efficient income stream increase over time even if market yields remain constant.
*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. And, 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 mitigate against the possibility that we remain in a low yield environment for longer than anticipated. Meanwhile, holding shorter maturity bonds helps ensure that if and when rates do rise further, there are opportunities to capture higher yields without having to liquidate existing holdings at a loss.
Why hire an active manager like PIMCO to build a bond ladder?
The municipal market has over 50,000 issuers, and the decline of bond insurance has made independent 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 over $76 billion in municipal assets (AUM as of December 31, 2021), we may be able to provide economies of scale in price and transaction costs that are passed on to investors. As the chart below shows, the average transaction cost for trades less than $10,000 was 0.90%, whereas institutional sized trade costs are considerably less.& As such, 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.
To learn more about investing in municipals at PIMCO, please visit pimco.com/munis
Disclosures
Unless stated otherwise, information contained herein is as of 31 December 2023. The information may be stale and should not be relied upon.
All investments contain risk and may lose value. 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 low interest rate environments increase this risk. 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 is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax; a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. No representation is being made that any account, investment product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Investors should consult their investment professional prior to making an investment decision.
PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns.
PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. 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 is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world.
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