|
Cents and Sensibility Guy Steele |
Diversifying bond holdings
by maturity can ease riskFOR the past several years, interest rates have been low. If you depend on fixed-income vehicles, such as bonds, for the income, you may be shaking your head in despair. What's an investor to do?
You could, of course, hope for interest rates to rise. And that may happen, particularly if the economy continues to improve. In the past, a strong economy has led to higher inflation, which, in turn, has pushed interest rates higher.
However, if you want to buy new bonds, you may not want to wait for potentially higher interest rates.
As an alternative, consider building a "bond ladder" by purchasing a variety of bonds with a wide range of maturities, short, intermediate and long term. When rates are rising, you use the proceeds from your maturing bonds to buy new bonds at the higher levels.
When market rates are falling, you'll continue to benefit from the higher rates offered by your longer-term bonds. (Generally speaking, longer-term bonds pay higher rates than shorter-term ones.)
Bond ladder benefits
In addition to helping provide you with an "all-weather" approach to investing in bonds, a bond ladder offers the following:» Potentially "smoother" returns. If you invest in bonds on a "start and stop" basis, your income and yield could fluctuate significantly. But by regularly reinvesting part of your portfolio in all market conditions, you can help to smooth out your returns.
» Potentially lower interest-rate and reinvestment risk. If you invest in high-quality, investment-grade bonds, and you hold them until maturity, you can be reasonably assured of receiving your principal amount (or face value) back. And yet, both short-term and long-term bonds carry their own risks. When you buy short-term bonds, you face "reinvestment risk" -- the risk of having to reinvest matured or "called" bonds at a lower interest rate. (Bond issuers can "call" some bonds by repaying your principal to you before the bond is scheduled to mature.) And when you invest in long-term bonds, you incur "interest-rate risk" -- the risk that your bonds could lose value if interest rates rise. But when you create a bond ladder, your mix of bonds can lessen both these types of risk. (Keep in mind, though, that bond ladders can't protect you from all risks. You have to consider the risk of default associated with a particular issuer. Obviously, the higher the credit risk, the greater the possibility of losing some, or all, of your principal. Also, all bonds face inflation risk: the risk that your bond's yield (at the time the bond matures or is called) will not outstrip the rate of inflation, and, consequently, not provide you with a positive return.)
» Greater investment discipline. If you follow a structured investment plan, such as a bond ladder, you can help yourself make steady progress toward your long-term goals. By sticking with your bond ladder, you'll be less likely to make changes based on short-term market events, such as sudden changes in interest rates.
As you can see, a bond ladder has much to offer. So, think about establishing one -- it can help lift you out of the gloom of the "low-rate latitudes" we find ourselves in.
See the Columnists section for some past articles.
Guy Steele is a financial planner and head of the Pali Palms office of Edward Jones. Send planning and investing questions to him at 970 N. Kalaheo Ave., Suite C-210, Kailua, Hawaii, 96734, or call 254-0688