If you invest in bonds and certificates of deposit, you may be dismayed at rising interest rates of late. But it's not all bad news for your fixed income investments. There is a way to proactively deal with the situation and come out ahead. For years, financial planners have been recommending a strategy known as bond laddering.
What is a bond ladder? Think of a seesaw. When interest rates rise, the value or price of a bond falls below its par or face value (assuming you bought it new). That's because other investors aren't willing to pay the face value of the bond when they can invest the same amount of money in a similar new bond paying higher interest.
In a falling interest-rate environment, the reverse is true. Investors will pay more for an existing bond that hasn't reached its maturity in order to hang onto higher interest rates. The longer the maturity of a bond, the faster the price of the bond falls or rises in relation to changing interest rates. Of course, if you hold onto individual bonds until they mature, you should receive their face value (unless there's a default) regardless of any price changes during the holding period.
But there are ups and downs for bondholders. On the positive side are the higher earnings from interest on your bonds, especially in the wake of such low rates that we experienced for so many years. Now, it appears that the Fed will continue to raise rates for a while.
What's negative is that you probably don't want your money tied up long term should interest rates continue to rise, so you may be focusing only on short-term bonds and CDs. You also don't want to risk being in longer-term bonds and watching the prices drop if rates climb (however, the price of a CD you already own won't change when general interest rates change).
But did you know the riskier longer-term securities generally pay more interest than shorter-term securities? That's where the bond ladder can help, because it reduces that risk of interest-rate changes while allowing you to take advantage of higher rates.
How To Ladder Your Bonds
The trick is to buy individual bonds or CDs with a mix of maturities. Example: you might buy roughly equal dollar amounts of various U.S. Treasury securities, with each maturity date representing a different rung on the ladder. Recently the yield on three-month Treasury bills was approximately 2.8 percent, six-month bills yielded 3.1 percent, two-year notes yielded 3.5 percent, five-year notes yielded 3.9 percent, and ten-year Treasury notes brought 4.2 percent.
Then, when the shortest-term security matures on the bottom rung of the ladder, you reinvest the proceeds in the best-returning rung, which usually is the top rung of securities with the longest maturity. In time, the shorter-maturity, lower-paying rungs will be gradually replaced by higher-paying, longer-maturity securities.
Why not just buy the higher-paying, longest-maturity securities in the first place? By using the ladder approach you always have some securities maturing every few months or every year, depending on how you construct your ladder. This lets you take matured securities and invest at the highest available rate. You also could cash them in without risk of loss of principal should you need the funds.
You can build ladders out of most types of fixed income securities, depending on what's appropriate for you and what level of risk you're willing to take. You also can build your ladder only as far out in maturity as you feel comfortable with or that you need. You might also want to go out five or seven years instead of ten or longer.
The general advice is that you need a minimum of $100,000 in order to cost-effectively buy sufficient numbers of individual bonds to build an effective ladder (transaction costs are not an issue for CDs). If you don't have enough to invest in a ladder of individual securities, it's possible but more difficult to build a ladder out of bond mutual funds. The problem with funds is that they usually have no definite maturity date and individual investors can't control redemptions. But some funds focus on bonds with certain maturities, such as ultra-short, short, intermediate, or long-term bonds, so you could build a rough version of a bond ladder.
Herb White is a Registered Representative of and offers securities through Woodbury Financial Services, Inc. Member NASD, SIPC