With bond yields stubbornly camped near historic lows, is there a way to invest in fixed income while limiting our exposure to rising interest rates? Yes. Bond ladders are a fairly simple approach to doing just that. Bond ladders work differently from bond funds because bonds have a component that bond funds do not- fixed maturity dates. In simple terms, if you hold a bond to maturity, you will receive the principal back no matter how interest rates have moved during the holding period. The value of a bond fund at the end of the same period may be higher or lower depending on how interest rates have changed. (Remember that bond prices fall when interest rates rise and vice versa.) Therefore, if rising rates are a major concern, individual bonds can be used to guard against loss of principal.
A bond ladder is constructed by purchasing bonds (or other income investments with maturity dates such as a CDs) in even intervals and dollar amounts extending out into the future. For example, if we have $100,000 to invest, we could purchase 5 bonds for $20,000 each maturing in 2015, 2016, 2017, 2018 and 2019. Under normal market conditions, bonds of similar credit quality would pay slightly more interest the further out their maturity dates. For simplicity sake, let’s say that the 2015 bond pays 1%, 2016 pays 2%, and so on through 2019. The first year we would earn 3% on our ladder. Assuming steady interest rates, if we reinvest the principle each year back out at the 5-year point, after 4 years all of our bonds would be earning 5%.
The increasing yield of the ladder over time is nice, but wouldn’t we have earned more by just buying one 5-year bond that paid 5% or buying a fund holding bonds with an average maturity of 5 years? Yes, but only if rates hold steady or fall. What if rates rise? With the individual bond, we cannot reinvest the principal (or even have access to it) until it matures in 5 years without risking a loss by selling it at a lower price. The bond fund is even more vulnerable to rising rates. Since the fund’s maturity is maintained at a 5 year average, a steady rise in rates continues to erode the value of the fund. There is no point in time that we can be certain of recovering our initial investment.
Tell Us What You Think – Is a Bond Ladder an investment tool you’ve used?
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