Bond ladder can help protect your fixed-income portfolio

In many investment advisory offices the worry isn’t about the economy, or stocks, or real estate. No, the worry is about the investment normally used to eliminate worry: Bonds.

Why the worry? It’s better for bonds when interest rates go down. That is why the last 10- to 20-years of bond returns look similar to stocks.  Across that time period interest rates came down rather dramatically to the almost non-existent state they are in today.

Well, if lowering interest rates is good for bonds, guess what is bad for them? Given how low yields are right now, most would agree that across time rates will go up, not down. Those bond mutual funds you may have been using up to now show some great returns across the last 5 and 10 years. However, if you look at how they did in 2013 and what might happen in the next 5 and 10 years you may be in for an unhappy surprise. Are you worried yet?

Now, I’m not predicting that rates will soar anytime soon. But before they do, let’s look at a tried-and-true method for protecting your fixed-income portfolio: The Bond Ladder.

A bond ladder is simply sequencing the maturity date on your bonds so that they come due across many years. For instance, you might buy $20,000 each of a 2, 4, 6, 8, and 10-year Treasury bond. To keep the ladder going, every time one of the bonds comes due you’d buy a 10- year bond. In this way you won’t be caught in the whipsaws of interest rate movements.

Since you’ll be holding each bond until maturity, you eliminate any permanent loss of principal. Because one is coming due every so often, you can always just not buy a new one if unexpected cash needs arise. If interest rates are rising, you get to lock in some new juicier rates. If they are dropping, you’ve already locked in the rates from earlier.

We’re not trying to guess the direction of interest rates; we are trying to eliminate the possibility that large moves in them will dramatically affect our portfolio. Albeit, removing the possibility of getting it all wrong also eliminates the possibility of getting it all right too. But bond investors are typically more interested in avoiding the downside than trying to hit home runs on the upside.

To be clear, when interest rates go up, you’ll see your account statement suffer even though you are holding individual bonds. But in this case you will know that is temporary. As long as you hold the bond to maturity you know exactly how much you will get for it in the end. So even if things look dire now you have the assurance that you won’t be left holding a loser. (Of course, it does require the entity issuing the bond to still be around, which is why Treasury notes and bonds are popular.)

There are some other ways of achieving a bond ladder. Some exchange traded funds buy a basket of bonds that all mature in the same year. You could buy several of these baskets to build a ladder. Other investments also can be used, and you should know that buying bonds is a lot different than buying a stock or mutual fund. But I’ll have to let you or your advisors sort out those details.

This article was published under the title "Bond ladder can help protect your fixed-income portfolio"

in the Wichita Falls Times Record News on March 9, 2014