(The following is an abridged copy of an article published by BMO Global Asset Management. A complete copy can be accessed at www.bmogamus.com.)

The last few years have seen interest rates hold steady or drift lower, causing investors to be concerned about how their fixed income portfolios will be affected when rates eventually rise. The question is, how can investors protect themselves from rising rates while still earning income while they wait?

Laddered Strategy Pros and Cons

Many conservative investors have preferred to use a traditional bond ladder as a fixed income strategy. A laddered strategy is relatively simple to construct and manage. When a bond matures, another is selected that will match or extend the longest existing maturity in the ladder. This takes the emotion out of trying to time interest rate moves and provides investors with the peace of mind that comes from having a specific maturity date for each bond.

A bond ladder strategy also has its downsides. Unless the portfolio is significantly large, there may be a relative lack of diversification of individual credits. To mitigate this risk, investors are likely to invest in only high-quality bonds despite their modest yields. Similarly, if money is needed before a bond matures, an investor would be subject to prevailing market conditions. Moreover, if and when interest rates do rise, awaiting the maturity dates on the longer bonds in the ladder may seem like an eternity to an investor wanting to reinvest at higher yields.

Bond Ladder vs. Fund Ladder

There may be a better way. Conservative investors seeking capital protection against rising rates, but who also want to enhance income while they wait, should consider a fund ladder. Done properly, a fund ladder may offer a better risk/reward profile than a laddered portfolio of individual bonds for all but the largest investors.

To help illustrate, we considered a hypothetical $1 million fixed income portfolio using either a bond ladder or a mixture of tax-free funds. The fund selections were weighted to provide the same duration as the bond ladder and a similar average credit quality. The bond ladders selected were a 1- to 5-year (Figure 1) ladder. (NOTE: The unabridged article also considers a 1- to 10-year ladder, but any maturity-range bond ladder could be used.)

The funds selected for this comparison were the BMO Ultra Short Tax-Free and the BMO Short Tax-Free Funds. Some of the advantages that the fund ladders provide are:

  • Greater diversification — This mixture of three funds contains more than 1,000 individual issues vs. 20 individual holdings in each bond ladder.
  • Yield advantage — The average yield advantage using the funds relative to the 1- to 5-year bond ladder is 58 basis points ($5,785 in annual income).
  • Floating rate exposure — While there is no floating rate exposure in the bond ladder, the fund ladder example has a 25% (1- to 5-year) floating rate allocation. This may offset some of the final maturity certainty provided by a bond ladder.
  • Liquidity — Should investors in a bond ladder need to access a portion of their funds prior to a maturity date, funds can be sold on any business day at the closing net asset value.

Summary

No one knows when interest rates will rise or the magnitude of the increase when it does occur. It is appropriate, however, for investors to consider the impact on their fixed income portfolios in a rising rate scenario. Traditional fixed income strategies may no longer be the best approach in a stable-to-rising rate environment. A fund ladder may provide greater diversification and liquidity than a traditional bond ladder, while offering the potential for additional income. We encourage investors to think differently as they prepare their fixed income portfolio for the future.

Assumptions

All yields are assumed as of 6/30/13.

The individual bonds yields assume an AA bond in each respective maturity and are provided by Municipal Market Data Corp via InvestorTools Perform. The BMO fund yields are the 30-day SEC yields for the I-share class and are net of fund expenses.

The floating rate weighting in the example assumes the allocation in each fund as of April 30, 2013. The specific fund floating rate allocations were 50%, 25%, and 10% for the BMO Ultra Short Tax-Free Fund, the BMO Short Tax-Free Fund and the BMO Intermediate Tax-Free Fund, respectively.

Keep in mind that as interest rates rise, bond prices fall. This may have an adverse effect on the Fund’s portfolio.

Interest income from Tax-Free Fund investments may be subject to the federal alternative minimum tax (AMT) for individuals and corporations, and state and local taxes.

All investments involve risk, including the possible loss of principal.

You should consider the Fund’s investment objectives, risks, charges and expenses carefully before investing. For a prospectus, which contains this and other information about the BMO Funds, call 1-800-236-3863. Please read it carefully before investing.

BMO Global Asset Management is the brand name for various affiliated entities of BMO Financial Group that provide trust, custody, securities lending, investment management, and retirement plan services. Certain of the products and services offered under the brand name BMO Global Asset Management are designed specifically for various categories of investors in a number of different countries and regions. Products and services are only offered to such investors in those countries and regions in accordance with applicable laws and regulations. BMO Financial Group is a service mark of Bank of Montreal (BMO).

BMO Asset Management Corp. is the investment adviser to the BMO Funds. M&I Distributors LLC is the distributor. BMO Funds are not marketed or sold outside of the United States.

This is not intended to serve as a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. Information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. This publication is prepared for general information only. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk. Market conditions and trends will fluctuate. The value of an investment as well as income associated with investments may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance.

Investment products are: NOT FDIC INSURED — NO BANK GUARANTEE — MAY LOSE VALUE.

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