Bond Ladder: Going Up?
Let us suppose that you are a retiree with a
large enough nest egg to provide for your desired standard of living
until age 99 for both you and your spouse. You have thrown a security
blanket over your plan by making arrangements for any long-term illness
via insurance coverages or other means and your main interest is
protecting your savings and seeking moderate growth opportunities with
your investments. You realize that some stock market exposure is
necessary to stay ahead of inflation and his evil twin taxation, but
also require a good portion of your portfolio to be in fixed income
investments. One of the more popular strategies that seems to make its
way into the media during bear markets is the bond ladder.
A bond ladder is a fairly easy concept. By
purchasing bonds at different, evenly spaced time periods and holding
them to maturity, you will always have some liquidity and your average
yield will be higher with less risk. In today’s interest rate
environment however, the longer term bonds are not providing much of a
yield advantage. Five-year bonds currently yield in the 2.75 to 3.25%
range with 10 year in the 3.5 to 4.0% category. Since interest rates
are likely to go up again before these bonds mature (how much lower can
they go after all), you would essentially be buying long term CDs. In
other words, because bond values go down as interest rates go up, you
would be forced to hold securities that are paying very low rates that
you could not sell without experiencing a loss in principal. Most
investors don’t realize that the volatility of long term bonds can be
close to that of common stocks because of this inverse relationship of
interest rates and principal. However, a primary purpose of bonds in any
portfolio should be to dampen volatility – not increase it. The
investors who mostly use long term bonds are institutions such as
corporate pension plans or life insurance companies that have fixed
obligations over time. Generally, they are not concerned with
volatility of principal because of their fixed maturity date and amount.
An alternative that may work well in the
current low interest rate environment is to use an Ultra Short bond
mutual fund. These funds typically hold only AAA investment grade
securities with maximum maturities of one year. Total returns for the
12 months ending 9/30/02 are around 3.95% with 12-month yields around
2.75 %.* So when interest rates do go up, you will have the benefit of
rising rates with frequent maturities that will capture a better yield
without tying up your principal for longer periods of time. Since the
fund is 100% liquid at all times, there is no need to wait for a
maturity date. This type of fund is also an excellent “parking place”
for money that is ear marked for the stock market at a later date or for
funds that are needed to settle a short term liability.
So in a time when it is anyone’s guess as to
when the interest rate trend will turn around, we say consider the
alternative that will give you the most flexibility and invest
prudently.
* Return data taken
from Morningstar database for DFA One-Year Fixed Income (DFIHX)
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