The value of a 
Bond ladder lies in its yield 
But not in its price

Tracking the performance of equities (aka stocks or stock-based funds) is an easy task these days. Free software can show pretty graphs of price changes over time for a single holding or your whole portfolio. Our firm’s performance tracking software, Black Diamond, is an example of a full-featured version of this kind of tool.

While some stocks and ETFs can pay income through dividends, people generally think of stocks, ETFs, and mutual funds in terms of their potential to grow in price. The hope is that you’ll buy a stock at a certain price and sell it for a gain later. “Buy low, sell high” is price-based advice. The equation for compounding returns incorporates only price and time, not reinvested dividends.

Bond ETFs and mutual funds suffered in dramatic fashion in 2022. A bond’s price moves inversely to its Yield to Maturity. You can picture a teeter totter, with a bond’s price on one end and its Yield to Maturity on the other end. In the center of the teeter totter is the bond’s Coupon Rate, or Nominal Rate. As you move to the edge of the see saw you get Current Yield, the Yield To Maturity, and the Yield to Call, which may be greater or less than Yield To Maturity. To accommodate the fuzzy relationship between Yield to Call and Yield To Maturity, there is another metric called Yield To Worst, which displays the lesser of the Yield to Maturity or Yield To Call.

Confused yet? Here’s a picture to help:

(in the above image, Yield to Worst would equal Yield to Maturity, because it less than Yield to Call).

If an investor buys a bond at a discount, that pushes the Price side down and the Yield side up. Why does that happen? Because when the bond matures, the investor gets its $1000 face value, which will be greater than the discount price paid for the bond. That extra income factors into the Yield to Maturity calculation.

The reverse is true when bonds are bought at a premium. Yield to Maturity goes down because the investor will make less than what he or she paid for the bond when it matures. That loss gets factored into the YTM calculation.

In 2022, as bond yields increased due to the interest rate hikes pushed by The Fed, the market price of bonds with older, lower interest payments diminished in value. Bond ETFs and mutual funds look no different in a portfolio than a stock ETF or mutual fund, and the market price of those ETFs and mutual funds fell as interest rates rose. This naturally created alarm for investors holding these funds in their portfolios. Their allocations to these theoretically lower risk investments were facing price losses over 13% in some cases.

While bond fund prices took a tumble in 2022, increased interest rates meant investors could see steadily increasing annualized yields in short term Treasury Bills and money market funds. As of this writing, the 3 month Treasury is yielding an annualized rate over 5.1%.

Instead of buying bond funds, an investor may avoid the risk of price swings by owning individual bonds and holding them to maturity. Why?

Because the bond will repay its face value when it matures. This face value is $1000 per bond. By holding the bond directly, rather than in a fund, the investor has control over the holding period of the bond. The investor can choose to hold the bond to maturity, which makes pre-maturity price swings irrelevant.

When it comes to measuring bond performance, herein lies the problem: the “if held to maturity” value of a bond portfolio cannot be expressed in a performance graph.

An investor knows the amount of money he or she will make over the course of a bond’s lifetime the moment he or she buys the bond. The bond has an annual coupon (interest) rate, and then there is the $1000 per bond the investor will receive when it matures. If the bond issuer pays off the debt in advance (“Calls” the bond), the call price is listed as part of the bond purchase. The investor can count on the lesser of the Yield to Call or Yield to Maturity. This “lesser of” figure is called the “Yield To Worst.”

The point is, if an investor intends to hold a bond to maturity, there is no utility in watching its market price in a rising interest rate environment. The market price will show losses, but those losses will never materialize because the bond will be held to maturity and the face value returned to the investor.

Charting a bond portfolio on a performance graph should come with a warning label: “May Lead To Needless Feelings of Bummed Outness.”

But, instead of a warning label, whoever designed financial lingo instead came up with special terminology to describes yield-based investments.

Stocks are referred to as Equities. The value of the stock is an expression of the value of the company in which the shareholder invests. The company is worth X, and your equity is a slice of X.

Bonds are referred to as Fixed Income. The value of the bond is in the income it produces – NOT in the value of the issuing entity – and that income is fixed at the time of purchase.

Bond ladders are an excellent way to create a diversified bond portfolio with consistent income. The investor purchases bonds with a range of maturities. Those bonds generate an average yield for the whole bond portfolio. As the shortest term bonds mature, they return their face value, which gets reinvested into a new high “rung” of the ladder.

For example:

A bond ladder could consist of bonds maturing in 3 months, 6 months, 9 months, and 1 year. As the three month bonds mature, they get reinvested in new purchases of 1 year bonds, which would mature three months later than the 1 year bonds purchased at the time the ladder was first built. In this example, even though the ladder is only 1 year, it rolls through time like a tank tread, adding a fresh rung of 1 year bonds every three months.

As the bonds mature, the investor can seek bonds of similar rating and similar yield to worst. This allows the investor to generate consistent “fixed income” from this part of his or her portfolio.

However, just like a bond ETF or mutual fund, the bond ladder will have a market price over its lifetime. In a rising interest rate environment, the market price of the longer term bonds – the bonds in the top rungs of the ladder – will fall. Higher interest new issue bonds available on the market will depress the price of the bonds on the ladder paying the old, lower interest rate.

But, as long as the bond is held to maturity, this is not a problem.

The short term bonds will mature, pay their $1000 per bond, and that money will be reinvested to buy the higher interest bonds available at that time.

But what about our pretty performance graphs?

They may not look kindly upon the bond ladder. As the market price of a bond falls, an investor may be alarmed to see that their bond ladder – which they bought for safety and consistency – has declined in value. The graph will show a downward trend and the investor may think that their portfolio has lost money.

This is a completely incorrect way of viewing bond performance.

A bond ladder never sells bonds on the open market unless they can be sold at a premium relative to their purchase price. Otherwise, the bonds are held to maturity and the investor receives the Yield To Maturity or Yield To Call stated at the time of the bond purchase. Remember, if a bond is held to maturity, it’s market price at any point from purchase to maturity is irrelevant to the investor.

The concept that the market price of a bond is a poor gauge of its value in a portfolio sometimes catches people by surprise. Most investors don’t buy individual bonds. They buy bond funds, or balanced funds that contain an allocation to bonds intermingled with investments in stocks. They evaluate the performance of these holdings based on their market price over time. In this way, investors are trained to evaluate fixed income allocations using the wrong system.

Using market price to evaluate bond value is like using a magnifying glass to look at the moon. It’s simply the wrong tool. The investor instead needs to pay attention to Yield To Worst (the lesser of Yield To Maturity or Yield To Call) and the number of months or years to maturity.

Based on the complexity of bonds and how they shouldn’t be monitored the way stocks and stock funds are, I’ve heard many investors state bluntly that they “don’t like bonds.” Bonds are undeniably complex instruments, with weird and specialized jargon associated with them.

Current yield, nominal yield, yield to call, yield to maturity, yield to worst, premium, discount, face value, duration. These are all essential concepts to understand when investing in bonds. Naturally, many investors throw in the towel and buy a fund instead. However, as we saw in 2022, the bond fund purchase exposes an investor to the very price risk that bond purchases should avoid.

As interest rates on extremely safe bond investments like short term Treasuries eclipse the 5% mark, now is an excellent time to consider a bond ladder for any part of your portfolio where you want to take risk off the table.

The only way to know whether a bond ladder might be right for you is to first understand how they work and what they do. Education is the most important thing we do at SeaCure. If you are like many investors and are bewildered by how to implement a bond ladder that achieves both the safety and yield that you need in your portfolio, we’d love a chance to speak with you.