Bond Ladders

ladderFixed Income investments have been thrust to the forefront of investment discussions due to the Federal Reserve’s decision to reduce their bond buying program by $10 billion.  Over time, the reduction in demand is widely believe to help push prices of bonds lower, consequently raising yields.  It is important to have tools at your disposal in managing how rising interest rates can impact your bond portfolio.

One of the safer ways to handle rising interest rates is to maintain a laddered bond portfolio.  Historically this has been done with individual bonds but can also be built using maturity date ETF (or ETNs).  The simple concept is to build a “ladder” or a bond portfolio that has bonds maturing in a variety of years over a specified time frame.  For example, you may elect to have $10,000 worth of bonds maturing every year for the next ten years.

During rising interest rate environments, building a bond portfolio in high-quality bonds this way helps in two key ways.  First, one of the attractions to bonds is that at maturity you will receive back par value.  The security inherent in getting back par helps by insuring that you will not be held holding a position that is stuck at a lower value.  In contrast, a return to par value does not exist when investing in stocks.

As discussed, over time as rates rise the previously issued bonds must adjust in price to reflect the change.  Because we are holding to maturity we don’t care about these changes.  But by building a portfolio with bonds maturing each year, you are able to take the maturing value and reinvest the proceeds into bonds paying higher interest rates.  For example, with a ten year horizon when a bond matures we would take the proceeds and buy a new ten year bond that is paying a current (likely higher) interest rate than the one that matured.

This laddered structure allows for investors to reduce the volatility in their portfolio and slowly ride up the interest rate curve as bonds mature, slowly increasing the income produced.  Unfortunately, in environments where rates are declining, the bonds that mature are invested at lower rates, slowly reducing the income produced.  However, the general concept to understand is that by having multiple bonds maturing in multiple years you minimize any significant sudden changes to the yield of your bond portfolio.

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