One of the constant dilemmas of bond investing is making the trade-off between risk and return. Do you want bonds with long maturities that provide higher returns (with more risk), or do you want bonds with short maturities that offer lower returns and less risk?
In chapter four of "Higher Returns from Safe Investments: Using Bonds, Stocks, and Options to Generate Lifetime Income," Marvin Appel pointed to a third way, one that boosts returns and manages risks at the same time.
Called “bond laddering,” this strategy involves buying individual bonds with different maturity dates; for example, 20% of your bonds mature in two years, 20% in four years, 20% in six years, 20% in eight years and 20% in 10 years.
To illustrate how laddering works, Appel created a simple, theoretical portfolio made up of:
- One-year bonds paying 1% interest per year.
- Two-year bonds paying 2%.
- Three-year bonds paying 3%.
Once this $30,000 portfolio is set up, say in the year 2010, the fund will pay total interest of $600 per year: ((1% + 2% + 3%) / 3 = 2%)), and 2% of $30,000 is $600. Assume in this scenario that interest rates remain the same throughout.
In 2011, after the one-year bonds mature, they are rolled into new three-year bonds (the three-year bonds from 2010 will now mature in two years). The portfolio now consists of:
- One-year bonds that pay 2% (these were two-year bonds when purchased in 2010).
- Two-year bonds paying 3% (these were the previous three-year bonds).
- Three-year bonds paying 3% (these are the ones newly purchased).
After one year, the return from this portfolio goes up from 2% to 2.66% ((2% + 3% + 3%) / 3). Therefore, the value of your coupon income just went up by a third.
In 2012, the process repeats itself again, and the portfolio now contains three sets of bonds:
- One year to maturity yielding 3%.
- Two years to maturity yielding 3%.
- Three years to maturity yielding 3%.
Once again, the full income stream has gone up, from 2.66% to 3%, without taking on any additional risk from maturity dates (the portfolio still has bonds maturing in one, two and three years). As Appel summarized, “In effect, you are getting coupon interest commensurate with three-year bonds from a portfolio whose average maturity is just two years.”
For clarity, he provided this table:
That laddered portfolio was created to explain the concept. According to Appel, a more typical bond ladder would be like the one with which we opened the chapter:
- Two years.
- Four years.
- Six years.
- Eight years.
- Ten years.
In this portfolio, the benefits of laddering would take longer to unroll, but the gains also increase: “Every two years one fifth of your bonds would mature and you would reinvest that amount in ten-year bonds. After four such reinvestments (eight years), every bond in your portfolio will pay coupon interest characteristic of ten-year bonds even though the average maturity of your portfolio will be just six years.”
So, laddering has the potential to boost yields, but what about the interest rate risk -- usually the most serious risk for bond buyers? It turns out this strategy can moderate risk.
If you have a laddered portfolio and interest rates go up, then the overall value of the bonds in your portfolio will go down, in line with the standard relationship between bond prices and interest rates. But each time a bond hits its maturity date, you can sell it for its full price and reinvest in a new bond paying a higher interest rate. The blow of higher interest rates will be softened.
On the other hand, if interest rates go down, the value of the bonds goes up. When you sell a bond that has reached maturity, you get back what you paid in principal, but you have to reinvest the principal at lower rates.
As Appel summarized, “The overall effect of bond laddering on interest rate risk is that the interest rates at which you buy your bonds will end up being an average of available rates over the years—sometimes at high rates and sometimes at low rates.” Laddering works for all types of individual bonds, including target-date bond mutual funds (all bonds mature in the same year).
Since it takes a number of years for a bond ladder to be fully realized, the author encouraged investors to start their ladders early. For example, if you plan to retire at age 65, then you would want to start before the age of 55. If you can do that, all your bonds will be paying 10-year rates by the time you stop working.
In the same vein, if you start early enough, you could start without buying different maturities. Instead, it would simply be a matter of buying 10-year bonds every year.
Appel wound up the chapter with these words:
“Bond laddering is a safe strategy that is suitable for you if you have a brokerage account in which you can buy individual bonds. Constructing a bond ladder portfolio for yourself will ultimately generate the high levels of coupon interest that characterize long- term bonds without tying up all of your assets in such bonds. Bond laddering removes the necessity of having to time the bond market because your bond ladder will ultimately represent the average of interest rates available.”
Read more here:Ă‚
Higher Returns From Safe Investments: Risks for BondholdersÂ
Higher Returns From Safe Investments: Bond Basics, Part 2Ă‚
Higher Returns From Safe Investments: Bond Basics, Part 1Ă‚
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
