Bond investors, welcome to Lake Woebegon!
There’s a surprisingly easy way for retirees to have the bond portions of their portfolios become, like the mythical children of “Prairie Home Companion” fame, above average. That’s because you can construct a portfolio of bonds whose total return will almost certainly be higher than the average of those individual bonds’ yields.
Better yet, getting this happy result requires no special abilities or market timing prowess.
I am referring to what’s known as a bond ladder: A portfolio of bonds with maturities spaced at one-year intervals up to some so-called “top-rung” maximum. Such a ladder undertakes transactions just once a year, taking the proceeds of the shortest-term bond as it matures and reinvesting it in a new bond whose maturity is at that top rung.
Since the idea behind a bond ladder is that each bond is held to its maturity, most of us would guess that the total return of a ladder would be equal to the average of those bonds’ individual yields. Believe it or not, however, the ladder’s total return in most cases will be close to the higher yield of the longest-maturity bond it owns.
That is how bond investors can be above average. And it seems too good to be true.
Yet this very much was the finding of a study that was published in 2015 in the Financial Analysts Journal, entitled “Bond Ladders and Rolling Yield Convergence.” Its authors were Martin Leibowitz and Anthony Bova, managing director and executive director at Morgan Stanley MS, +2.47% respectively, and Stanley Kogelman, a principal at New York-based investment-advisory firm Advanced Portfolio Management.
Consider what this research currently means for a bond ladder containing U.S. Treasurys of maturities from 1-year to 5-years. The current yields of each of the component bonds are shown in the table below.
| Maturity of U.S. Treasury | Current yield |
| 1-year | 2.27% |
| 2-years | 2.54% |
| 3-years | 2.68% |
| 4-years | 2.76% |
| 5-years | 2.84% |
The average of these five individual bonds’ yields is 2.62%. In fact, however, the study’s authors found, the ladder’s longer-term expected return will be quite close to 2.84%, the current yield of its longest-maturity bond.
How long is that long term? Three to four years, Leibowitz said in an interview. That’s not even as long as the maturity of the top-rung bond.
This happy outcome isn’t guaranteed. If the yield curve flattens significantly from its current upward slope, or even turns negative, then the ladder’s total return may diverge from the yield of its top-rung bond. Fortunately, the yield curve the vast majority of the time is upwardly sloping.
In fact, the yield curve historically has been more steeply upwardly sloping than it is today. When that is the case, the alchemical yield boost of investing in a bond ladder is even greater than the 22 basis points in my hypothetical example.
To be sure, my hypothetical bond ladder won’t make 2.84% each and every year. Depending on what happens to interest rates in the next year or two, it could do much better or worse over the near term. But, assuming you hold the bonds to maturity, reinvest any proceeds in new bonds with top-rung maturities, and hold for at least 3 to 4 years, your expected return will be quite close to that 2.84%.
All you need to do is make one transaction a year. Not a bad way of being above average.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com.