Understanding Municipal Bond Ladders in a Rising Rate Environment
What is a bond ladder?
A bond 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?
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. In an environment where yields are elevated and the yield curve is positively sloped, the longer rungs of the ladder bring the average yield of the portfolio higher.
Another benefit of ladders is their ability to take advantage of rising rates, through mitigating downside by investing based on a hold-to-maturity approach. This allows an investor to capture some of the potential upside by holding shorter maturity bonds that help to ensure that if and when rates do rise, there are opportunities to capture higher yields without having to liquidate existing holdings at a loss while 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 should converge toward the yield of the longest maturity bond in the laddered portfolio – this is the income stream increase over time even if market yields remain constant.
Figure 1: The Mechanics of Climbing the Bond Ladder
Source : PIMCO. For Illustrative Purposes Only
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 has over $74 billion in municipal assets under management as of December 31, 2023), 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 between $25,000 and $100,000 has averaged 0.54% over the past five years whereas institutional sized trade costs have been 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.
Figure 2
As of 31 March 31 2023
Source: MSRB. Spreads are based on the trade volume weighted daily difference between the average dealer-to-consumer buy price and average dealer-to-customer sale price. There is no guarantee that institutional sized trades will result in improved pricing. Institutional sized trades are those over $1,000,000, transaction costs are derived from MSRB analysis with data obtained from MSRB’s RTRS database.
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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