If you're a bond investor, changing interest rates are a fact of life. To withstand-or possibly even benefit from-a changing interest rate environment, you need to take interest rate volatility into consideration when planning your bond investment strategies.
A common mistake many bond investors make is failure to diversify, not only by asset class, but by maturity. Structuring a portfolio with only short-term securities subjects an investment to reinvestment risk. If interest rates go down, a bond's maturing principal will earn lower returns when you reinvest it.
Conversely, although holding long-term securities may typically provide higher yields, they may not offer sufficient liquidity to allow you to take advantage of new investment opportunities.
Since the exact highs and lows of interest rates can't be predicted, many wise investors opt to construct a portfolio with a variety of maturities, from short term to long term, seeking to increase portfolio return and reduce exposure to reinvestment risk. This is called the ladder portfolio strategy.
A ladder portfolio is structured to help investors in all economic climates by taking into consideration current interest rates, as well as anticipated future rate changes. This strategy has become increasingly popular among fixed-income investors as an innovative yet conservative means of diversifying bond maturities within a portfolio. When maturing principal becomes available for reinvestment, you can reinvest it in either short-term or long-term securities, and/or vary your portfolio's asset mix, depending on current interest rates and your financial objectives at that time. With a ladder, each investor directly owns, and may sell, each bond as he or she chooses. Ladders aren't managed.
Suitable For Every Interest Rate Environment
If interest rates rise, you can reinvest principal from the ladder's maturing short-term securities into longer term, higher yielding securities and effectively increase your portfolio's overall return. Liquidity is maintained in your portfolio as the securities originally purchased approach maturity over time.
If interest rates fall, you've already locked in higher yields through the long-term securities in your portfolio, thereby minimizing reinvestment risk. You can reinvest maturing principal into shorter term securities to further enhance liquidity in anticipation of future rate increases, or you can extend maturities to capture higher current rates.
If the interest rate environment remains stable, you can continue your current investment pattern of reinvesting principal to increase overall portfolio yield and maintain
If you're seeking the security of a debt obligation backed by the U.S. government, ladder portfolios work well with taxable, fixed-income securities such as government-backed zero coupon bonds or U.S. Treasury securities. Depending on your investment objectives, you can also construct ladders using other fixed-income investments, such as high-quality corporate bonds or preferred securities. Although a ladder portfolio may not outperform other investments, including bonds of a particular issuer or maturity date, it may help reduce risk over time. IBI