For the average bond investor, getting into a game of predicting where interest rates will head over the near-term is likely a losing proposition. At the beginning of 2014 if you had followed the popular consensus and avoided bonds with the 10-Year Treasury at 3%, or worse yet shorted bonds, it would be you on short end of the call. In 2013, if you made a big bet on long bonds prior to the now renowned “taper tantrum,” well, let’s just say it was not the best time to buying long-term bonds.
Thus, the average bond investor who looks at fixed-income primarily for its cash flow consistencies or as a diversification component to an equity dominated portfolio – not as an interest rate bet – is best served employing a passive bond investment strategy. The best known of passive strategies is development of a bond ladder. A ladder more or less removes emotion and guesswork from the equation by spreading out rate risk, generally requiring a “hold until maturity” mentality on the part of the investor.
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A ladder can be built in any number of ways, but the more “rungs” in the ladder, i.e. total number of bonds in the portfolio, the more effective the ladder can be. The goal of the ladder is to establish a periodic, methodical approach to portfolio maturity. Some ladders may comprise a handful of bonds that mature every couple of years, while others may be comprised of dozens of bonds that mature several times a year. Creation of the ladder probably won’t be instantaneous, and may be dependent on available capital and willingness to invest all at once as opposed to dollar cost averaging in over time.
Initial implementation of the ladder presents some of the most difficult choices for an investor. Decisions must be made on how many bonds to buy, the blended maturity of the holdings, how much to allocate to each bond, and as mentioned above – how quickly purchase execution will take place. Admittedly, with rates still hovering at historic lows and the threat of higher interest rates continuing to loom, today presents a challenging environment in which to develop a bond ladder.
If the rate environment is troubling, I would certainly advise keeping maturities as minimal as possible to achieve acceptable yields. If you develop a ladder with ten bonds that mature every two years, you basically establish a 10-year blended maturity. If rates start to increase by the time your first bond matures in 2016, you’ll be able to reinvest that bond at a much higher rate, especially if you are willing to go out 20 years to keep bond duration constant.
For investors more concerned about maximizing income and less concerned about the opportunity costs associated with holding long-term bonds in rising rate environments, a longer duration portfolio should be established. More bonds with 20+ year maturity may be purchased while shorter-term bonds are minimized in such a portfolio.
Over time, investor needs or the interest rate environment may change, requiring subtle or more notable alterations to portfolio credit quality, blended duration, and/or yield needs. Ergo, a ladder should be somewhat flexible. If a bond matures and there’s reason to change the shape of the ladder to an extent, some level of artistic license should be employed.
In the end, a bond ladder represents a staggered-maturity-blueprint to diversify and craft a mainly buy-and-hold portfolio that hedges interest rate fluctuations. While it may take time to establish, goals of a well thought out ladder should include ample income production, thoughtful blended maturity, and credit quality that the investor can sleep well at night with.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.