A laddered bond portfolio allows investors to have bonds spread all along the yield curve so they constantly have bonds maturing, enabling them capture the highest yields available.
If rates are rising you can take advantage of it by reinvesting your short term bonds that are maturing, Even if rates are dropping you still have bonds you purchased when rates were higher. You also have the oppertunity of investing in bonds with different coupon dates so you can have monthly income rather than having one issue that pays twice a year.
Your interest rate risk can be greatly lowered with a laddered portfolio. If rates are falling and your bonds are being called you still have issues that pay higher coupons, higher than you can currently get, and are passed their call dates. If rates are rising you have bonds constantly maturing so you have cash to buy bonds that are paying a higher coupon than other issues you have.
I am not going to go over any specific bond issues here nor will I go in any great detail the different types of bonds available. This strategy will work, whether you have corporate bonds, municipal bonds, or Agency bonds.
You will need a bit more capital to invest than your average investor. I would recommend you begin with a minimum of twenty to forty thousand dollars. For those investors with smaller amounts to invest in bonds, you may want to take the barbell approach which requires much less capital and is a fairly good strategy to use. However it is not a strategy I will cover today.
Most clients who make good candidates for a laddered bond portfolio choose this method because it provides an income that is steady, predictable, and safe. At the same time it reduces the common risks associated with investing in fixed income products.
As you know, bonds only pay out once every six months, so it is hard to use as a primary source of income since your capital will be locked up for some time.
Here are some of the advantages of a laddered bond portfolio.
- Safety in numbers
- Predictable and steady stream of income
- Reduces Interest Rate Risk
- Diversification
Safety in numbers. There is little risk when purchasing government and municipal bonds as they are backed by the full faith and credit of the issuing agency or municipality. Even with the shaky economy investors are pouring a billion dollars a week into municipal bonds which are federal tax free and in most instances, state and local tax free. Keep in mind that if you live in California you need to purchase California Municipal bonds. If you purchase New Yorks municipal bonds you will be hit with both state and local taxes. California bonds are still very high rates so there is little risk. Your greater risk, and the need for a greater number of issues lies with the investor who is purchasing low investment grade BBB bonds, or even lower grades.
A predictable and steady stream of income. Unlike preferred stocks that usually will pay a monthly dividend, bonds payout twice a year. Most investors who are putting a higher percentage of their working capital in bonds, need income more than twice a year. This is where you do your research. Given time, you will be able to find enough different bonds with different coupon dates that you will be able to structure your portfolio to have monthly income. While you can purchase 6 different issues to ensure exact monthly income, many people are satisfied with less.
Reduces interest rate risk. Bonds are coming due daily, and eventually yours will too. They may be put back to you because of a call feature or they may just reach their maturity date. Interest rate risk comes into play when you have all your available capital locked up in, for example, twenty year muni bonds paying five percent. The market changes, prices plummet and bond yields soar. However you have no funds to take advantage of todays new higher rates. You are stuck with five percent while todays buyer is getting five and a quarter. You can sell any issue before maturity at the market rate, but you are bound to take a loss here. You may have purchased your bonds at par-1000.00/bond- but as yields have rocketed upwards, the bonds in your portfolio that have a coupon of five percent have seen their value plummet as investors are buying five and a half yields. Most bonds have a call feature, generally at the two year or five year mark. If yields are falling and the market is selling four and a half percent bonds your issuer is not going to sit by and pay your five percent. If the difference in yields is great enough the issuer will buy your bonds and you will be left with a chunk of change and unable to reinvest at the yield you were enjoying.
This is where we get into the next part of the laddered bond strategy. Not only do you want your coupon payments varied throughout the year, you want to diversify your maturity dates. While you will want some long term bonds because of the great return you are getting you also want some two year bonds, or even a one year issue so that every year or so you have a bond maturing that is going to give you new capital to invest at the new higher rates. Since one cannot predict when an exchange of bonds will be favorable it is good to have several different maturities. You may want to have issues maturing every few years or so. The drawback to that is it takes considerable capital to have that many issues, hence the barbell strategy. I wont get into the specifics here as it is pretty self explanatory. One would have a number of long term issues and a couple of two year issues. As the bonds come due you reinvest the cash at the new market rate.
Diversification. It's always good, but not so vital in reducing risk when you are talking agency bonds, treasuries, and high rated corporate bonds. Although with some municipalities being downgraded by Moody's and Standard and Poor's, one should not turn a blind eye to it. If you have lower rated debt in your portfolio then you will want to have a number of different issuers as well as different sectors of the market. In other words, you may want to cover different sectors of the market like you would a stock portfolio.
In summary. For the bond investor, a laddered bond portfolio is a great way to arrange your income in a way that best suits your income needs while greatly reducing your various risks associated with investing in the market.
Here are some additional bond resources you may wish to access:
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