Achieving duration target via ladder or fund?


R

Rich Carreiro

My previous post brought the underlying abstract question to
mind, so I figured I'd ask that, too:

Given that you want some chunk of your fixed income holdings
to have an average duration of N years, what are the pros/cons
of achieving that via a suitably-structured ladder (whether
out of individual bonds or defined-maturity finds) or via
a traditional fund of bonds in that space that holds a
constant duration of N years.

At least on the surface it would appear to me that all
else being equal the ladder would be preferable since
at any time you know what your total return will be to
the end of the ladder, as opposed to the always unknown
total return of owning a constant duration bond fund.
 
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D

David S Meyers CFP

My previous post brought the underlying abstract question to
mind, so I figured I'd ask that, too:

Given that you want some chunk of your fixed income holdings
to have an average duration of N years, what are the pros/cons
of achieving that via a suitably-structured ladder (whether
out of individual bonds or defined-maturity finds) or via
a traditional fund of bonds in that space that holds a
constant duration of N years.

At least on the surface it would appear to me that all
else being equal the ladder would be preferable since
at any time you know what your total return will be to
the end of the ladder
That "known" total return assumes (a) you only ever plan on holding
every securiy to maturity (i.e., no reinvestments, no sales, no
withdrawals; (b) ignores whatever return you get on the dividends along
the way (since even if you know the yield to maturity, you only
actually get that if you can reinvest the dividends along the way at
that same rate); and (c) only care about the total return from one
specific point in time to another, not in general along the way.
, as opposed to the always unknown
total return of owning a constant duration bond fund.
At any point along the way, the total return to that point of a fairly
illiquid individual bond portfolio is (a) "made up" - you don't know
what you'll actually get for any individual bond until you've actually
sold it; and (b) at least as volatile as the fund (because of (a)).
The main difference is that every day along the way, the bond fund
effectively makes you an offer for the at-that-time value of the
portfolio. You have no such real offer for the ladder.

That all said, if you are comfortable holding each security until
maturity and not having to sell at rotten times, you can take the other
side of the "sell at rotten times" trade by buying, usually through a
dealer who specializes in such, odd-lot batches of individual bonds
that said dealer got at great prices from others. And you don't pay an
ongoing management fee along the way, either - even a fairly low one
of, say, 20-30bp is a big chunk to take out of the profits on a
security which is only paying, say, 300bp in yield anyway.

Additional benefits of the fund approach, however, include the ability
to much more easily do things like pull in your duration when you think
rates will rise, shift asset classes if you think one is more or less
over/underpriced than another (i.e., as Bogle recommended recently,
more corporates and less treasuries).

Unless you have a huge, absolutely huge bond portfolio, you cannot make
those kinds of tactical moves without running into the illiquidity and
bid/ask spread issues which eat individual investors alive.





--
David S. Meyers, CFP®
http://www.MeyersMoney.com
disclaimer: discussions in misc.invest.financial-plan are for
educational purposes only and should not be construed as financial
advice. For personal financial advice, please consult directly with a
professional.
 

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