Step on the Bond Ladder

It's not easy to predict the direction of interest rates. When the Federal Reserve began raising short-term rates in June 2004, conventional wisdom said that long-term rates would follow. But long-term interest rates have mostly defied conventional wisdom.

In an environment marked by fluctuations, it's important to have a method to help protect your portfolio from changes in the direction of interest rates.

Spread It Around

Assume that you purchased several bonds with the same maturity date. When these bonds mature and you want to roll your principal into new bonds, you have little recourse if interest rates are low.

Now assume that, instead of buying bonds that all mature at the same time, you constructed a bond ladder. Let's say you buy five bonds with varying maturity dates – one that matures in two years, another in four, and so on, up to 10 years. If interest rates have fallen when the first bond matures in two years, you would only need to reinvest one-fifth of your bond portfolio at the lower rate. Because your other bonds are still earning the higher original rate, the overall effect of the lower rate on your portfolio is reduced.

If interest rates are more appealing when the next bond matures four years from now, you might be able to reinvest for potentially higher income. Conversely, if none of your bonds had matured during that year, you might have missed out on the opportunity to reinvest for a higher yield.

The principal value of bonds may fluctuate due to market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investments seeking to achieve higher rates of return also involve a higher degree of risk.

Bond prices fluctuate inversely with changes in interest rates. Therefore, a general rise in interest rates can result in a decline in the value of existing bonds.

A bond ladder has no effect on the risk of bonds themselves, but using this strategy may put you in a better position to benefit when rates are high, while also having some protection against falling rates.

By purchasing bonds that mature at intervals, rather than all at once, you may be structuring your portfolio to withstand the inevitability of fluctuations in interest rates.