Investor Education | Climbing the bond ladder
Astute investors may add bonds to their portfolios for greater stability. However, while historically they are not as volatile as stocks, bonds are affected by rising and falling interest rates.
Basic principles: If interest rates rise before a bond's maturity date, you will be saddled with a below-market rate for the term of the bond. In that case, you could sell the bond at a loss or hope to invest the principal at a higher rate when the bond matures.
On the other hand, if you hold a bond until its maturity date, the reverse occurs if interest rates fall. Investors will pay more for a current bond that hasn't reached its maturity. The longer the time before a bond matures, the faster the price of the bond rises or falls in relation to changing interest rates.
There is a relatively simple way you can protect yourself against interest rate fluctuations while managing the cash flow from bond investments. It is called a "bond ladder."
How it works: Instead of buying, say, one $100,000 10-year bond, you buy ten $10,000 bonds with varying maturities, beginning with one year and going up to 10 years. As a result, you own bonds maturing every year for the next 10 years. This provides a laddered portfolio of short-term, mid-term and long-term bonds.
If interest rates go up and you have a bond maturing soon, it can be reinvested at a higher interest rate. You can reinvest a maturing one-year bond each year for 10 years to keep the ladder going. If interest rates drop, only a small portion of your portfolio—the maturing one-year bond—must be reinvested at the low rate.
Watch your step: Using a bond ladder is like any other investment strategy. You should move cautiously and only after you have investigated all your options. Here are a few basic points to remember:
- Find out when the bonds can be called, if at all. The rules may differ depending on the type of bonds you have acquired. Key point: Know all the details before you invest. As a rule of thumb, you may want to concentrate on bonds that cannot be called.
- Invest only in high-quality bonds. Be careful about using certain corporate and municipal bonds to build your ladder. Reason: Changes in the credit status of the entity that issues the bonds could mean that you won't receive your interest or principal on time. Even worse, the issuer may default.
- The ladder does not need to have a rung for every year. For instance, you could choose bonds that mature at two– or three-year intervals. But adding more rungs increases the diversification.
Fortunately, you do not have to go it alone. Seek professional guidance concerning investment decisions.
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