Income investors are naturally drawn to bonds. After all, they provide guaranteed income for minimal risk.
However, bonds can be problematic when yields are expected to rise.
At the moment, short-term bonds yield almost nothing – but if yields rise, long-term bonds decline in price, leaving investors with a capital loss.
So what should bond investors do?
Fortunately, there’s a way to mitigate interest rate risk with a technique called bond laddering. Even for individual investors who may be relying on investment income for their retirement, it’s a technique worth considering.
In the simplest form of bond laddering, an investor divides his capital into a number of equal tranches – let’s say five – and invests each tranche in Treasury notes maturing in successive years. At present, the 1-year Treasury yields 0.24%, the 2-year yields 0.66%, the 3-year yields 0.94%, the 4-year yields 1.18%, and the 5-year yields 1.43%.
Thus, by investing an equal amount in bonds maturing in each of the next five years, an investor will get an average yield in the first year of 0.89%. Not very exciting, I agree. However, it gets better as you go on.
Once the 1-year bond matures, you reinvest it in a new 5-year bond at 1.43%. Now, while still owning bonds with maturities of one through five years, you’re getting a yield of 1.13%.
As future bonds mature and are replaced with new 5-year bonds, your yield will continue to rise. In five years’ time, if interest rates remain constant, you’ll be receiving a five-year yield of 1.43% on bonds with an average maturity of three years.
Laddering also provides an advantage when interest rates rise.
If rates have risen by 1% in a year’s time, then your maturing 1-year bond will be reinvested in a new 5-year bond at 2.43%, boosting the overall average yield to 1.33%.
Of course, laddering doesn’t enable you to get the full benefit of interest rate rises immediately. But it does give you reinvestment cash each year while minimizing the principal risk from investing in longer-term bonds during a period of rising interest rates.
Upping Your Ladder Game
There are several ways to improve returns if the five-year ladder isn’t sufficient.
First, you can divide your money into 10 equal tranches, rather than five, and invest in 1- through 10-year Treasury notes. This gives you a higher immediate yield of 1.39% that continues to rise as each maturing 1-year note is reinvested in a new 10-year bond.
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The disadvantage is that the 10-year strategy gives you less flexibility to reinvest as rates rise. In this case, after three years, only 30% of your portfolio has been reinvested while the other 70% is trapped in lower-yielding bonds bought in the initial allocation.
Another strategy to goose your returns is laddering with prime corporate bonds rather than Treasuries.
For example, a 1- through 5-year ladder with A-rated corporate bonds would yield 0.60% on 1-year bonds, 1.01% on 2-year bonds, 1.37% on 3-year bonds, 1.74% on 4-year bonds, and 2.11% on 5-year bonds.
That equates to an overall average yield of 1.36% in the first year and 1.67% after one reinvestment, assuming interest rates haven’t moved.
As with Treasury bonds, this is advantageous mostly when interest rates are rising, because you’ll avoid the inevitable price declines that come from seeking higher yields in 10-year or 20-year bonds.
The main difficulty in laddering with corporate bonds is that you can’t buy a generic A-rated bond – you have to buy an obligation of a particular company, and you’re then exposed to the specific credit risk of that company.
Obviously, if one of the bonds on your ladder gets into difficulties, it may not pay principal on time or in full, in which case your losses are unlimited.
Climbing the Ladder
Overall, the yields available from bond laddering may seem unexciting.
However, that’s a result of the eccentric monetary policies pursued by Fed chairmen Ben Bernanke and Janet Yellen over the last seven years.
At some point, interest rates will rise, and then laddering will position you nicely.
Because of that flexibility, laddering is preferable to the other two alternatives: holding cash or buying long-term bonds.
Putting your money entirely in cash while waiting for yields to rise makes your yield today negligible. And long-term bonds not only expose you to the risk of substantial price declines if interest rates rise, they also prevent you from redeploying your money into more attractive investments when rates do eventually rise.
Thus, for the bond part of your portfolio, a laddering strategy should seriously be considered in today’s market.