Friday, August 30, 2013

Bond Ladders

Until recent years, bonds have been the foundation of a well balanced portfolio. While bonds are still necessary to cushion principal risk inherent in stocks, they provide miserably low rates of return in our current financial environment. Generally speaking individual bonds (other than Treasuries) are somewhat illiquid. If the owner of a Fredrick County Water and Sewer Bond needed to sell before the bond’s date of maturity, it might be difficult to locate a buyer unless the bond was sold at a discount. For this reason individual investors are better served by investing their money in low cost bond funds. These funds are highly liquid. They can be sold at posted, well understood share closing price on the day of the transaction. The money will then be available for the investor to spend in no more than a few days depending on the rules of the fund.

The problem with bond funds is interest rate risk. While these funds are frequently categorized as short, intermediate, or long term investments, their price (like bonds) moves inversely with changes in interest rates. If interest rates go up the value of a bond or bond fund that pays a fixed amount will drop. If interest rates go down the value of the bond or bond fund goes up.

A classic method of protecting the investor against interest rate risk is termed the “bond ladder.” While this method has dropped out of favor as interest rates have plummeted over recent years, it is being rediscovered by baby boomers (like me) in search of yield and safety.

Bond Ladder: “A portfolio of fixed-income securities in which each security has a significantly different maturity date. The purpose of purchasing several smaller bonds with different maturity dates rather than one large bond with a single maturity date is to minimize interest-rate risk and to increase liquidity. In a bond ladder, the bonds' maturity dates are evenly spaced across several months or several years so that the bonds are maturing and the proceeds are being reinvested at regular intervals. The more liquidity an investor needs, the closer together his bond maturities should be.” (Investopedia)

Consider a bond ladder of ten individual ten year bonds each with a different maturity date. In this hypothetical example, let us imagine all the bonds mature on January 1; one bond every year. Utilizing this method your entire portfolio is paying a ten year (long term) rate rather than the lower short term rate. Every year 1/10 of your bond ladder pays off allowing you to reinvest in a new ten year bond at the then current interest rate. As interest rates rise and fall your income is protected from unforeseen shocks to the economy.

Principal is protected as older bonds move towards maturity. If sold, they will command higher prices. Remember, short term interest rates are lower than long term interest rates. This means the long term coupon rate produced by your bond will result in a higher selling price. This phenomena is termed “surfing the roll” down the yield curve. This only works in normal times. In the case of an inverted yield curve, an unusual short lived event that usually indicates an oncoming recession there will be no roll to surf.

Dude! Like, what a bummer.”

All of these observations are also assuming that these bonds are not “callable.” Some bonds can be paid off before their due dates if interest rates plummet. It also assumes that these bonds hold on to their rating. Changes in ratings from junk to investment grade or visa versa will obviously change the results generated by your bond ladder.

According to Ed Easterling the total return of “seasoned” bond ladders (what does that mean?) with lengths of 10 years or less have been positive each year over the past 100 years. The problem I see is how best to start a bond ladder with interest rates near historic lows. It would appear there is only one way for interest rates to go—up! This does not seem like a very good time to put a lot of money in a new bond ladder.

Please! Let’s be careful out there today.

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