A traditional method to build a bond portfolio is to buy bonds with laddered maturities. A bond ladder protects against both rising and falling interest rates. Investing in a bond ETF can provide some of the benefits of a ladder without the trouble of researching and buying individual bonds. The best path is dependent upon your expectations from your bond investments.
Features of a Bond Ladder
Setting up a bond ladder involves buying a portfolio of bonds with staggered maturities. For example, you might buy equal amounts of Treasury bonds maturing each year for the next one to five years. After the ladder is established, a portion of the bond portfolio will mature on a regular interval and that money is reinvested into new bonds at the longest maturity level. Since longer-term bonds usually pay higher yields, the money from mature bonds is always reinvested at the highest possible rate within the parameters of the ladder.
Bond ETF Characteristics
A bond exchange-traded fund holds bonds to match the components of a specific bond index. The Index Universe database lists about 180 different bond ETFs covering the government, international, corporate and municipal bond markets. The ETFs that most closely match the investment results of a bond ladder are the target maturity Treasury security ETFs. For example, a Treasury ETF holding three- to seven-year Treasury bonds would show similar return characteristics to a bond ladder with Treasury bonds out to six or seven years.
Pros and Cons
Investing using a bond ladder strategy provides consistent results with safety of principal and the ability to regularly reinvest at the best current market rates in the maturity range of the ladder. Holding the bonds to maturity eliminates most of the transaction costs of buying and selling. Bond ETFs package a portfolio of bonds into a single investment. With an ETF it is easy to add to your investment amount or switch to a different portion of the yield/maturity curve by moving your money to a different ETF. You pay regular stock commissions to buy ETF shares and a fund's expenses will reduce the yield you earn.
If you plan for a long-term commitment for a bond portfolio and are comfortable with evaluating and buying individual bonds, a bond ladder provides the highest level of principal safety and the ability to adjust to changing rates. An ETF bond fund provides any easier path to earn bond market returns very close to the result provided by a bond ladder. The ETF choice allows you to profit from changing bond market prices, as well as earn a yield similar to the income earned from a bond ladder. The value of bond ETF shares will decline if interest rates increase -- a fate avoided by the buy-and-hold ladder strategy.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.