Not many investors can get excited about investing in bonds with interest rates near their 50-year lows. But rates have risen recently, so many investors are struggling with the question of whether to invest now or hold out for the possibility of capturing even higher yields down the road. While no one can predict when and by how much interest rates will change, the cost of waiting is quite clear.
The Time Value of Money
The old saying goes, 'A bird in the hand is worth two in the bush.' The same logic may apply to investing. When faced with a decision to invest today or wait, it is important to understand that the longer an investor holds out in hopes of higher yields, the more rates will have to increase to make up for interest forgone today.
Further, interest on money invested today can be reinvested to earn additional interest. Through this principle of compounding, it is clear that waiting for interest rates to rise becomes more expensive relative to investing today.
Real World Examples
Consider the following scenarios in which an investor has the option of investing in a five-year Agency note today or remaining in cash over the same period.
Under the first option, an investor buys a five-year Federal National Mortgage Association (FNMA) note today at a yield of 3.70 percent. On a $100,000 investment, the investor earns $3,700 each year. Under option two, the investor remains in the money market fund that initially yields 2 percent. Under the worst case scenario, let's assume money market rates remain the same throughout the five years, earning the investor $14,750 less than what would have been earned by investing in the Agency note. Under an optimistic scenario, rates increase by two percentage points in year four and rise an additional 3 percent in year five to 7.75 percent. Still, this scenario earns the money market investor $16,750, or $1,750 less than would have been earned by investing in the FNMA note.
As you can see, an investor would have to correctly guess the timing and magnitude of an interest rate increase to win at this game. Further, the longer it takes for rates to rise, the harder it is to make up the interest lost to waiting.
A Cure for the Waiting Game
If tying up your money for five years sounds too long for you, consider a bond ladder. The bond ladder strategy is a time-tested investment concept geared for increasing predictability, control and performance.
To build a bond ladder, simply divide your investable dollars evenly among bonds or CDs that mature at regular intervals, say once a year. For example, divide $100,000 into five $20,000 investments with the first bond maturing in one year and the fifth in five years. By combining the higher yields of long-term bonds with the liquidity of shorter-term bonds, you can achieve more consistent returns and greater peace of mind.
Every investment involves a risk/reward trade-off. The less risk you are willing to assume, the lower the yield or return you can typically expect from an investment. Generally speaking, bond investors demand higher yields for shouldering market risk and credit risk.
Market risk is simply another way of describing the inverse relationship between bond prices and interest rates. If interest rates are rising and you don't want much fluctuation in your bond portfolio, stay short-term. On the other hand, if interest rates are falling from currently high yields, income-oriented investors may want to purchase longer-term securities. Bond ladders can be structured with short-, intermediate-, or long-term bonds. The bond ladder concept is an excellent strategy to minimize market risk.
Credit risk is the risk that the issuer won't make timely interest or principal payments. If you are concerned about defaults, construct your bond ladder with government securities, CDs, high-quality or insured municipal bonds, or high-quality corporate bonds. Although you many sacrifice some yield, you'll have comfort of knowing you own high-quality securities.
And, if a bond ladder does not fit your financial needs, there are always other investment strategies that can be employed such as investing in a money market fund or a single bond issue.