Later, Adams and junior portfolio manager Frank Neeson review the fixed-income portfolios of two new defined benefit plan clients, Lawson Doors & Cabinets, Inc., and Wharton Farms. Lawson’s plan has 30 participants, who are mostly experienced craftsmen and machinists, whereas Wharton has over 100 participants in its plan. The average participant age is 15 years younger for the Wharton plan compared with the Lawson plan. In both plans, participants receive a monthly benefit upon retirement based on average final pay and have no option for a lump sum distribution.
Neeson comments, “The durations for almost half of the bonds in the Wharton portfolio are clustered around 4 years, and the durations of the remainder around 12 years, while the durations of the Lawson portfolio bonds are clustered between 6 years and 8 years. In general, a laddered bond portfolio approach would improve liquidity management for both, although the Lawson portfolio would experience an increase in cash flow reinvestment risk and the Wharton portfolio would experience a decrease in convexity.”
Q. Is Neeson most likely correct in his assessment of the effects of a laddered bond portfolio approach on the Wharton and Lawson portfolios?
Yes
No, because the Lawson portfolio is a bullet portfolio where the duration of its assets are matched to the duration of its liabilities
No, because the duration of the Wharton liabilities is greater than that of the Lawson liabilities owing to the younger age of its participants
A is correct. A laddered portfolio has lower convexity and dispersion than a barbell portfolio but more than a bullet portfolio, given comparable duration and cash flow yields. Lower convexity and dispersion are desirable aspects in liquidity management. In a laddered portfolio, there is always a bond close to redemption enhancing liquidity. As bonds mature, the final coupon and principal are available for distribution or can be reinvested in a long-term bond at the back of the ladder. The Wharton portfolio is more of a barbell, has higher convexity than the Lawson portfolio, and would see a larger reduction in cash flow reinvestment risk with the reduction of convexity.
Neither duration nor the projected life of the plan reveal the convexity or dispersion characteristics of the portfolio.
Blockquote
Is it just me, or is this answer not really correct? That the laddered portfolios provide more liquidity, is clear. However, why is the reinvestment risk greater for the laddered portfolio?
Also, on convexity: barbell > laddered > bullet. Is it not the case?
And the more cash flows you have spread out (higher convexity), the more cash you have to reinvest and therefore you will be exposed to reinvestment risk.
Hi Fino Alabama,
Thanks a lot, Agreed on convexity: barbell > laddered > bullet.
Regarding reinvestment risk, I would have said that you have more reinvestment risk with laddered because there are constant repayments of bonds received (bonds are redeemed more often), plus you need to reinvest more often?
" more reinvestment risk with laddered than in bullet portfolio because there are constant repayments of bonds received (bonds are redeemed more often), plus you need to reinvest more often?"
Thanks, but I was wondering WHY it is like that.
Why does the barbell have the highest reinvestment risk? If I may ask you this additional question qithout being too annoying… Thanks!
Let’s say for Barbell strategy you’re holding 50% weight on short term bonds and 50% weight on long term bonds but nothing in intermediate bonds, therefore, you will face reinvestment risk when short term bonds mature as you might not find the replacement bonds when the int. rate now declines.
Let’s say your portfolio has a market value of $1,000,000. Your target Macaulay duration is 5 years.
Laddered Portfolio:
You split the funds equally into five parts and invest $200k each into a 1-year, 3-year, 5-year, 7-year and 9-year zero-coupon bonds. The portfolio will have a weighted MacDuration of 5 years i.e. 0.2(1) + 0.2(3) + 0.2(5) + 0.2(7) + 0.2(9) = 5.0.
So one-year from now, the 1-year bond will mature and you will have to reinvest the $200k into a longer-term bond. There is an element of uncertainty with the $200k with regards to the interest rate that we can reinvest at.
The next bond will mature in another 2 years and a reinvestment decision has to be made again (with uncertainty on the reinvestment rate).
Barbell portfolio:
Let’s say we split the portfolio equally into two parts and invest $500k each into 1-year and 9-year zero-coupon bonds. So the weighted duration is 0.5(1) + 0.5(9) = 5 years.
One year later, the 1-year bond will mature and now we have to reinvest the $500k and the reinvestment rate is unknown till then.
Comparatively, for the barbell portfolio, a bigger percentage needs to be reinvested ($500k versus the $200k) earlier than compared to the ladder portfolio, hence a higher reinvestment risk for barbell vs laddered portfolio.
And for the laddered portfolio, as the amounts maturing is spread out, you will have some buffer time before you need to reinvest the amount (hence why laddered portfolio balances out reinvestment risk vs price risk).
