Build a Bond Ladder With New Funds

EDITOR'S NOTE: This article was originally published in the July 2012 issue of Kiplinger's Retirement Report. To subscribe, click here.

The bond ladder, a classic strategy for income-focused retirees, is getting cheaper and easier to build. Although individual bonds are the traditional "rungs" of the ladder, a number of new mutual funds and exchange-traded funds can be laddered in ways that offer advantages to small investors.

These products seek to combine the perks of fund investing, such as diversification and relatively low costs, with benefits of individual bonds, including an ability to more precisely match income with future cash-flow needs. These funds "are great tools for building laddered portfolios," says Gene Koyfman, lead fixed income ETF analyst at IndexUniverse.com.

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In a traditional bond ladder, an investor might buy equal dollar amounts of individual bonds maturing in each of the next five years. As each bond matures, he can use the cash to cover expenses or reinvest in a longer-term bond to extend his ladder. The ladder reduces the risk of being stuck in lower-yielding bonds if interest rates rise. Since the investor always has a bond that's about to mature, he always has some cash to reinvest at higher rates.

The new funds' distinguishing characteristic is a defined maturity date. Traditional bond funds have no set maturity date, because individual bond holdings are continuously bought and sold. The new funds, by contrast, invest largely in bonds that are set to mature in a particular year. In that year, the funds typically liquidate and return assets to shareholders. (American Century Investments has for years offered a lineup of defined-maturity bond funds, but those funds are focused only on zero-coupon U.S. Treasury securities.)

Defined-maturity bond funds launched in recent years cover a range of fixed-income holdings, from tax-free municipals to taxable corporate and high-yield bonds. Fidelity Investments last year launched a lineup of defined-maturity Municipal Income mutual funds, with maturity dates in 2015, 2017, 2019 and 2021. ETFs in this category include a family of iShares S&P AMT-Free Municipal Series funds, with maturity dates each year from 2012 through 2017, and Guggenheim BulletShares Corporate Bond funds, with maturity dates each year from 2012 through 2020.

To construct a ladder using such products, an investor could simply stash equal dollar amounts in funds with maturity dates in 2014, 2016, 2018 and 2020, for example.

Less Costly, More Diversified

The products make bond ladders more accessible to small investors. While an investor needs roughly $100,000 or more to build a diversified ladder of individual bonds, a broadly diversified fund ladder requires a fraction of that investment. The iShares 2013 S&P AMT-Free Municipal Series ETF (symbol MUAB), for example, recently traded for just over $50 a share and held over 200 bonds. Compared with individual bond ladders, the funds' diversification benefits "reduce the risk dramatically," says Timothy Strauts, ETF analyst at Morningstar.

The funds also offer a pricing advantage over individual bonds. Small investors buying individual bonds often pay a hefty markup that's built into the price of the bond, making it hard to gauge the fairness of the price. Investors pay ongoing expenses for mutual funds and ETFs that are not charged on individual bonds, but these fees are relatively low. Fidelity's Municipal Income funds, for example, charge annual expenses of 0.4% of assets. And investors who need cash in an emergency can easily sell the mutual funds and ETFs, whereas it can be tough to sell individual bonds for a fair price in a hurry.

Ladders of defined-maturity funds do have drawbacks. Although individual bonds generally offer fixed semi-annual payments, the funds typically make fluctuating monthly distributions -- providing a less predictable income stream. And barring a default, individual bonds return principal to investors at maturity, while shareholders in defined-maturity funds aren't guaranteed a specific payout at the maturity date. But the funds tend to place proceeds from maturing bonds into cash-like instruments as they approach their liquidation date. That means investors are likely to see a fairly stable net asset value as they await their final payout.