Introduction
What does science fiction have to do with finance? The classic book The Hitchhiker's Guide to the Galaxy by Douglas Adams starts with the characters asking: What is the answer to “Life, the Universe, and Everything?” It turns out that the answer to this ultimate question has more to do with corporate bonds than you might think.
Short-term Treasury rates have fallen by 100 basis points (bps) and long rates have risen by 60 bps over the past year, according to Bloomberg. Predicting where interest rates will move next is much harder in the face of evolving fiscal and monetary policies. Inflation has been driving interest rate volatility for the last three years; stalled progress toward the Fed’s inflation goal and uneven economic growth could signal that more volatility is ahead. Laddered bond portfolios are a strategy for navigating such markets, since the proceeds from maturing bonds are systematically reinvested at higher yields.
Yet with ladders, as with most things in investing, the devil is in the details. One question we hear a lot is: What’s the optimal number of bonds in a corporate ladder that both provides diversification and limits transaction costs? We calculate that the maximum number of positions a ladder would ideally hold is 42, which just so happens to be the answer to Douglas Adams’ ultimate question.
What are the basics of ladders?
A laddered corporate bond portfolio has an equal weight of bonds in each maturity year. For example, a one-to-10-year ladder would have 10% of its market value maturing every year. Proceeds from the maturing bonds are reinvested in the longest maturity rung of the ladder.
It’s a simple structure with many possible benefits. Investors could potentially begin earning an attractive yield on their portfolio of investment-grade corporate bonds in as little as a day. Unlike bond ETFs, investors own the underlying bonds, so they have a good sense of the future coupon income. They also have diversified exposure to the most liquid part of the corporate yield curve, ensuring exposure even while the yield curve shifts and twists over time.
Many investors are familiar with dollar-cost averaging, or adhering to a fixed investment schedule, into markets over time. Ladders offer a mechanism for clients to automatically dollar-cost average because bonds have a fixed life. While an equal percentage of the portfolio matures each year, proceeds are invested in the longest maturity bonds. These typically have higher coupon rates. Over the last 15 years, 10-year corporate bond yields have exceeded one-year corporate bond yields by 170 bps on average, according to Bloomberg. This has historically provided a solid pick up in yield for investors while the ladder rolls. Should interest rates rise, investors could potentially see their income increase even more. Therefore, a ladder has the potential to generate consistent cash flow with an upward yield bias.
What’s the right number of bonds in a ladder?
To understand the optimal number of bonds to include in a corporate ladder, we seek to determine the right balance between diversification and implementation costs. We often decide both the most and fewest bonds that could potentially be included in a ladder portfolio to start.
We offer investors the flexibility of opening a separately managed account with an initial funding of as little as $100,000. For a ladder with a 10-year maturity structure, bond maturities are spread evenly over a decade. This means 10 bonds would be the minimum because that would be one bond per year. Considering a typical bond’s minimum piece, market value and portfolio risk limits, the maximum number of positions is 42—the answer to the ultimate question of “Life, the Universe, and Everything.” So that leaves us with an answer somewhere between 10 and 42 bonds.
There are several arguments for holding as many bonds as possible in a corporate bond ladder. Holding more bonds may enable the manager to:
- Manage cash inflows and outflows more precisely
- Distribute the portfolio across 18 major industry sectors
- Space bond maturities evenly throughout the year
- Potentially reduce reinvestment risk should rates dive lower during a flight to quality
A higher number of bonds may help reduce a portfolio’s exposure to the risk that one specific company’s credit profile deteriorates, and its bonds underperform. Corporate bonds rarely default while they have an investment-grade rating. The primary risk is that a position might be downgraded to high yield and become a fallen angel—a bond that used to be investment grade but is now categorized as a “junk” bond due to a reduction in the issuer’s credit rating. Using data since 1987, J.P. Morgan found that fallen angel bonds had lost 13% upon downgrade.1 So if an issuer is downgraded to high yield, a laddered portfolio of 40 bonds will experience half the loss of a portfolio with only 20 bonds. As an additional risk measure, we only buy bonds of issuers that our experienced team of credit analysts has reviewed and approved.
Since an equal percentage of a ladder matures each year, we round down and target 40 bonds in our one-to-10-year ladder. That’s four bonds per maturity rung. For our larger institutional accounts, we may increase the number of holdings depending on the account’s investment guidelines. But for most of our ladder clients, we find that 40 bonds may provide ample issuer and industry diversification to manage a company’s specific or idiosyncratic risk. This translates into 2.5% positions per issuer, which is approximately the same issuer exposure as the largest issuer in the ICE BofA 1-10 Year US Corporate Index.
However, if we added 10 more bonds, our analysis shows the potential incremental benefit to loss reduction in the event of a fallen angel would be marginal. Additional bonds also increase oversight costs, while yielding less than the higher yielding bonds already in the portfolio. A portfolio with a higher number of positions will cost more and have a lower yield, with little added diversification benefit. When we balance these benefits and weigh the implementation costs, we find that holding between 40 and 42 bonds is the ideal number.
Does increasing the number of bonds also increase transaction costs?
Increasing the number of bond holdings improves diversification. But when investing in a ladder structure, this doesn’t have the negative effect of higher transaction costs. To an investor, the cost to build a laddered corporate bond portfolio is the same, regardless of the number of securities involved or trades executed. That’s because bonds trade on a bid-ask spread, not a per-trade commission.
A 40-bond portfolio involves twice the amount of trading of a 20-bond ladder. The money manager bears the operational cost to execute and process incremental trades. They then leverage the growth in electronic bond trading and their in-house systems to accommodate the higher transaction volume while maintaining a competitive fee structure. We believe this is a win-win for investors, who gain access to diversified ladder portfolios at no additional cost.
The bottom line
Only time will tell the degree of interest rate volatility, or how well a ladder structure fares, but investors may take comfort knowing that their corporate ladder has been optimally diversified in an effort to navigate volatile markets. And knowing that 42 is the answer to the ultimate question of “Life, the Universe, and Everything” may also prove valuable should they ever appear on Jeopardy, given the frequent questions about Douglas Adams books.
1 J.P. Morgan, North American Credit Research, “How low can HG spreads go?”, February 16, 2021.
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Diversification does not eliminate the risk of loss.
Parametric and Morgan Stanley do not provide legal, tax, or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction or strategy described herein.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.
10.16.2026 | RO 4860058
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