Climbing the Bond Ladder
Laddering. It’s not just a way to get things off the top shelf. It’s a top-shelf financial strategy that may give you significant protection from interest rate volatility.
When I talk to clients who are thinking about their children’s futures, they usually think about laddering as a simple technique to ensure that a certain amount of cash becomes available each year of their children’s progress through college. They typically fund this ladder with zero coupon bonds. They use zeros and targeted laddering as a way to make sure that secure assets have been put away to fund a future stream of liabilities.
As security-conscious investors become more involved in managing their bond portfolios, however, they quickly recognize that the larger purpose of laddering a portfolio is to hedge against interest rate risk.
This article will cover various laddering strategies that may help you hedge against interest rate risk, and sometimes boost the return of your bond portfolio.
The Ladder as an Interest Rate Hedge
We may make our best-educated guesses about the direction of interest rates, or we may faithfully follow our favorite economist guru, but in the end, we don’t know with absolute certainty whether rates will remain flat, make a mild move, spike, or plunge. If we knew this, we would invest all of our bond money in the appropriate maturities for that known interest rate move. But we don’t know.
Therefore, the wary investor wants some protection. I prefer that Bond maturities be laddered in a range from 3 to 15 years and perhaps invest 10% of the portfolio with maturities in the 15 to 30 year range.
Why? Let’s say that interest rates go up. We may feel sorry that we have invested in longer-term bonds at rates that could be beaten now, but at least we have short-term bonds regularly maturing that we can reinvest at the prevailing higher rates.
What if interest rates go down. We may regret having invested in shorter-term bonds that will have to be reinvested at these lower prevailing rates, but at least we have locked in higher rates at the long-term end of our ladder. A laddered structure provides a mid-range rate of return and the overall income stream.
Weighting the Ladder
If you are a person who feels confident about making modest predictions about the direction of interest rates, and if you happen to be right, you can boost the yield of your laddered bond portfolio by weighting one end of the ladder, or in certain instances, weighting both ends of your ladder.
Say that you think interest rates will be steady or lower for the next several years. The economy is experiencing modest growth and little inflation and the rest of the world is at peace. In other words, you see a replay of the late ’50s and ’60s. You believe interest rates will be steady, give or take a half a percentage point or so.
With this scenario, you might want to weight your ladder lightly with bonds that would mature during the first five years of the ladder and more heavily in the later years of your ladder. If you believe that interest rates will be going significantly lower, you may want to buy only a few bonds for the short-term years (1-5), one bond every other year for the mid-term years (6-15), and weight the long-term (15-30) more heavily to pick up additional yield. You never completely abandon a presence in each of the segments: short-term, mid-term, or long-term as you could be wrong in your interest rate predictions.
Similarly, if you think inflation is likely to return and “run away” higher, you may want to weight your ladder more heavily at the short end, say during years one through five. That way, as interest rates rise in the next several years, you’ll have more bonds to reinvest at higher rates.
Varying the Ratings Along the Rungs of the Ladder
If you are strictly a treasury buyer, consider taking on a very modest risk and buy government agency bonds to mix with your U.S. treasuries. If you are slightly more risk tolerant, mix in several investment-grade bonds with ratings of BBB, A, or AA This can significantly improve your portfolio’s overall yield.
Consider these scenarios for using this mix in a bond ladder. Remember, short-term is 1- to 5-year maturities, intermediate-term is 6 to 15 years, and long-term is 15 years or longer to maturity.
Buy government or high-rated bonds for the intermediate and long end of the ladder, then use the short end of the ladder, perhaps those maturities from one to seven years, to invest in lower investment-grade bonds or in those bonds that are higher-rated “junk bonds” by Standard & Poor’s and Moody’s, say BB rated.
If you can tolerate a bit more risk, you can alternate every third bond on your ladder with a lower-rated bond.
Remember that mortgage-backed securities, such as Ginnie Maes, Fannie Maes, and Freddie Macs, can be looked at as bonds with a series of monthly and annual calls on them because of the mix of mortgages that are retired at different times. So, for your intermediate-term bonds in the ladder, say, years 7-12, you might want to purchase a larger-sized mortgage-backed bond than the others in your ladder and let it represent several years’ maturities. Ginnie Maes carry the full faith and credit guarantee of the U.S. Treasury as to the timely payment of principal and interest but pay nearly a full percentage more than a 10-year Treasury note. However, keep in mind that mortgage-backed securities represent an investment in a pool of mortgage loans; thus, the yield and average life will fluctuate depending on the rate at which mortgage holders prepay the underlying mortgages and changes in interest rates. Your financial advisor should explain how mortgage-backed securities react to different market conditions.
Taking Two Rungs at Once
If you don’t feel you have enough cash to diversify your bond portfolio into 15 different years, you may want to consider buying smaller bonds of $10 thousand or $15 thousand each, instead of several larger bonds. Or if you do prefer to purchase securities in larger denominations, you can skip every other rung on your ladder. The important point is to have bonds that adequately cover the short-, intermediate-, and long-term ranges of the maturity ladder in an organized manner.
It is better to spread even the most limited bond holdings over a longer maturity range. If interest rates do go much lower, and you don’t have enough of a spread for the term structure of maturities in your portfolio, your ladder won’t be much of a hedge and won’t help you maintain your portfolio yield.
The whole point of laddering your bond portfolio is to keep you from getting “wrung out” by fluctuating interest rates!
Bond laddering does not assure a profit or protect against loss in a declining market. Yields and market values will fluctuate, and if sold prior to maturity, bonds may be worth more or less than the original investment.