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Is a Bond Fund the Same as a Bond Ladder?

A reader writes in, asking:

“You wrote an article recently about CD and bond ladders. Isn’t buying a bond fund basically the same thing as paying the fund company to implement a bond ladder for you?”

Whether or not a bond fund and a bond ladder would serve the same purpose in a portfolio depends on what type of bond ladder we’re talking about. Specifically, is it a bond ladder that would be renewed on an ongoing basis as bonds mature, or is it a ladder that would be allowed to wind down over time by spending the money as it comes in?

(Some) Bond Funds Are Like Perpetual Bond Ladders

Many bond funds are analogous to bond ladders that are perpetually rebuilt as bonds in the ladder mature. For example, Vanguard’s Intermediate-Term Treasury Fund is roughly similar to a 10-year Treasury bond ladder in which you buy a new 10-year bond each time a bond matures. And Vanguard’s Total Bond Market Index Fund is analogous, but with other types of bonds (e.g., corporate bonds and mortgage-backed bonds) in the ladder as well.

It’s important to understand, however, that not all bond funds fit this description. The managers of some actively managed bond funds see it as their job to try to earn excess returns by predicting which way interest rates will move next. As a result, rather than working to maintain a relatively stable average duration for the fund, they will actively shift the fund’s portfolio back and forth between shorter- and longer-term bonds in an attempt to capitalize on their predictions.

Bond Funds vs. Non-Renewing Bond Ladders

While a bond fund and a perpetual bond ladder can perform similar roles in a portfolio, a bond fund would typically be a poor replacement for a bond ladder that you plan to wind down over time.

For example, a retiree might choose to build a ladder out of Treasury Inflation-Protected Securities (TIPS), with the intention of spending each interest payment as it arrives and spending the principal from each bond when it matures. Doing so would allow for a very predictable stream of inflation-adjusted income over an extended period of time.

By way of comparison, the results of holding a TIPS mutual fund and systematically selling a certain number of shares every year would not be so predictable. That’s because, when you liquidate shares of a bond fund, you’re effectively selling a hodgepodge of different bonds, all prior to their maturity dates. And when you sell a bond prior to maturity, you’re exposed to the risk caused by changes in bond prices that occur when market interest rates change.

In short, whether a bond fund is a suitable replacement for a bond ladder depends on:

  1. What kind of fund it is — actively managed funds with significant changes in duration are not at all the same thing as a bond ladder — and
  2. What purpose you want your bonds to serve. (If the point is simply for them to make up the low-risk part of a portfolio, a bond fund can be a good fit. If the point is to provide a highly-predictable source of income as you liquidate them over time, a bond fund is not as good of a fit.)

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Comments

  1. I would question the idea that bond ladders are immune to rate effects. That’s only true if you look at the raw $ value rather than purchasing power. It seems to me, if your goal is to spend in the future, that it’s purchasing power which matters.

    I’d go so far as to say that bond ladders are a sinkhole unless you value your time at nearly zero or have some unusual needs. If you decide you want to be long bonds just buy TLT or whatever duration bond fund you want and walk away.

  2. W,

    When saying that bond ladders provide a predictable stream of income (such that you wouldn’t have to worry about changes in interest rates), I was specifically speaking about a TIPS ladder, which would have inflation protection.

    As far as the time involved, personally I certainly lean toward more hands-off options as well. On the other hand, when the bond ladder isn’t being renewed, I would imagine the ongoing work is relatively minimal.

  3. A TIPS ladder will have negative returns right now though. Unless the thing you want to buy is food that will rot, it seems like you’d be better off just buying the thing you wanted.

    I guess I won’t say a bond ladder is completely useless, but I having a hard time picturing who would want it. Most people who want future consumables (and thus might buy a TIPS ladder) would also want the actuarial aspects of an annuity I would think. Am I missing something here?

  4. I agree that in many cases an annuity is preferable. That said, some people simply aren’t going to buy an annuity one way or another. They just aren’t OK with the idea that the money is gone when they die, even if they die very shortly after purchasing the annuity.

    As as “just buying the thing you wanted,” that’s obviously impractical for things other than food. As far as physical goods, you can only store so many. Many things that you’ll eventually want haven’t even been invented yet. And then there’s just the fact that most people right now don’t know exactly what they’ll want to purchase many years from now.

    In other words, I agree that TIPS yields stink. And I agree that lifetime inflation adjusted annuities are a better choice for many people. But I still think that leaves a TIPS ladder as a reasonable choice for many investors (and, to get back to the point of the article, that a bond fund cannot serve exactly the same purpose).

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