Thursday, 13 August 2009

Bond Ladder vs a Bond Fund? Part1: Ladder Pluses

Bonds, or fixed income, have a place in every portfolio. Two ways to hold bonds are in a fund, either an ETF or a mutual fund, or in a ladder of individual bonds. How do the two methods compare? This post looks at advantages of the Ladder approach while Part 2 will review the advantages of Funds.

Bond Ladder
A bond ladder (more detailed explanation on Investopedia) consists of a series of bonds that mature at staggered, regular intervals, often chosen to be about one year apart. They can be bought online at many discount brokers, though it may be necessary to phone and speak to a representative. The bond price includes an implicit one-time fee charged by the broker - i.e. the bond's price is slightly higher.

Some discount brokers have a better inventory and wider selection of bonds. BMO Investorline seems to have a good inventory from the experience of this writer but check around. The embedded commissions can also vary between discount brokers.

Advantage to the Ladder:
  1. A ladder is more flexible: one can match maturities to desired cash flow, shorten or lengthen the number of years in the ladder or select issuers, whether corporate, municipal, provincial, federal government to control risk
  2. Ladders can reduce price risk (the risk that the bond's price will drop if interest rates rise) - if the bond is held to maturity, the par value will be returned and the investor receives the return/yield promised at purchase. A fund's asset value constantly shifts with interest rate changes, and there is never a maturity date for the fund, so an investor wanting cash may need to sell at a loss.
  3. Commissions and costs can be very low if bonds are held to maturity - though the commission on a bond trade is around 1.25% (according to Shakespeare's bond page) there is no recurring admin or management cost on the bond and, if held to maturity, the cost averaged over years goes down to very small amounts. By contrast the cheapest bond ETFs charge 0.25% annually. Nevertheless, if you start actively buying and selling bonds, your commission costs will be quite high, i.e. my opinion is that a bond ladder is for holding bonds to maturity.
Where to Find
  • Individual Bonds - look under Fixed Income on your broker website; for below-investment grade high-risk bonds or real return bonds, you would need to phone the broker bond desk


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- Norman

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