A popular strategy for investors in individual bonds has been and remains the laddered structure. Over the past year, the short end of the yield curve has risen at a faster rate than the intermediate and long parts of the curve, leading to a flatter yield curve and more relative value in short maturity bonds than we have seen in the past 10 years. But when considering how to position your fixed income allocation, it is important to consider where current value is as well as your individual long-term plan as an investor. Although there is a lot of value in shorter maturity bonds, I wanted to highlight the ladder structure and why it still might make sense for investors constructing a long-term investment plan.
First, what is a bond ladder? A bond ladder is a portfolio of bonds with maturities spread over regular intervals. So for example, a 1 to 10 year bond ladder could have a bond maturing every 6 months extending out 10 years. The idea is that whenever a bond matures, you reinvest the proceeds back on the long end of your ladder (in this example at 10 years), so you essentially always have the same general structure in your portfolio and the portfolio has regular investments at current interest rates.
Mitigate Reinvestment Risk: By spreading maturities out over a range of years, you are diversifying your reinvestment risk. Just as a properly constructed portfolio should diversify to avoid a saturation in any one issuer or sector, you also want maturity distribution, preventing the need to “market time”. By picking a small window of maturities where you see the most value (i.e. all short maturity bonds), you are exposing yourself to concentrated reinvestment risk.
Take Advantage of Rising Rates: In a rising rate environment, a bond ladder allows you to take advantage of the rising interest rates, while being fully invested and earning income along the way. As interest rates rise, cash flows and maturing principal are reinvested back into the bond ladder at the new higher interest rates, leading to a gradual increase in the overall yield of the portfolio over time.
Diversify Maturities: A bond ladder prevents the potential pitfalls of “betting” on a single future scenario (i.e. allocating all of your money to 5-6 year maturity bonds, for whatever reason). By doing this, you are potentially missing out on locking in higher yields for a longer timeframe with longer maturity bonds, which you may regret should interest rates begin to fall. You are also exposing yourself to the reinvestment risk mentioned above by not having the “rolling liquidity” that a bond ladder provides. If your forecasting skills prove to be less than perfect and your “bet” at one point on the curve does not play out exactly as you predicted, you will likely end up wishing you had diversified a little more. In the same way that you wouldn’t place your entire equity allocation in one company, you do not want to place your entire fixed income allocation in one maturity. Diversifying maturities is important because the future is unknown.
Regular Liquidity: The regular maturities in a bond ladder can also provide the investor a source of liquidity should unexpected expenses arise, without requiring the investor to sell a bond prior to maturity, which could potentially result in a loss of principal. The regular maturities also provide the opportunity to reposition the portfolio (different asset classes, sectors, credit quality, maturity range, etc.) over time as deemed appropriate by changing investment objectives and/or market dynamics.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
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