Fearing rising rates, some municipal investors have sought protection in passive laddered portfolios. The strategy’s seeming simplicity packs a lot of allure—but also hidden risks.

Investors who build traditionally laddered portfolios to protect against rising rates are likely to be disappointed by the low yields they’ve locked in. And some investors—particularly those who build higher-yielding ladders—are taking on a surprising amount of volatility. Last autumn, investors in five- to 15-year ladders learned the hard lesson that risks should be actively managed.

KICKING AWAY THE LADDER

Laddered portfolios are built with bonds spaced evenly across maturities so that the proceeds are reinvested as each bond matures. The traditional ladder is a 10-year one in which the investor purchases a 10-year bond, a nine-year bond and so on, down through a one-year bond. A year later, when the one-year bond matures, the investor then buys a new 10-year bond so that the ladder resembles its original configuration in terms of maturity.

These portfolios are simple to construct and maintain, provide relatively certain return, and gradually capture higher yields as interest rates rise.

But here’s the first hitch. In today’s low-interest-rate environment, that return is going to be locked in at low levels—levels even below the Fed’s inflation target. For example, portfolios laddered from one to 10 years yield only about 1.8% today—and that’s before accounting for trading costs and other fees.

At that yield level, there’s little chance to beat even a modest rate of inflation. And if inflation isn’t yet on your list of concerns, it should be.

TOO LITTLE, TOO LATE

Another hitch? While it’s true that passive laddered portfolios capture rising yields, it takes a long time for the investor to receive any meaningful benefit.

When interest rates rise, an investor in a laddered portfolio has to wait until the shortest bond matures in order to purchase a longer bond at a new higher yield. Playing the waiting game often means missing out on opportunities, including adding value through fluctuations in interest rates.

Investors in actively managed municipal portfolios, meanwhile, are in a much better position to benefit from rising yields.

To begin with, active managers can pursue a tax swap strategy: selling bonds bought when yields were lower, realizing a loss for tax purposes and buying a new higher-yielding bond.