Mitigating interest rate risk through bond ‘ladders’
There’s been a lot of talk lately about the inevitable rise in interest rates, including particular concern on behalf of bond investors. While there is consensus that rates will rise, no one is sure when. The US is still recovering from the great recession, economic growth is slow, and median household income has declined. It is conceivable that interest rates could remain low for quite some time. Taking the Fed announcements at face value, interest rates will rise when economic conditions in the US warrant it.
The concern of bondholders is valid, as the value of bonds will indeed decrease when rates go up. If rates are up, your market price will be lower and vice versa if rates go down. As a result, investors can see wide fluctuations in value depending on maturity dates, and this can be unsettling.
The good news is bonds that pay a fixed coupon (some have a variable coupon) will pay a steady stream of income regardless of interest rate movement. Since the coupon is fixed, the income from the bond will remain unchanged – no matter what the current price is. Thankfully, we are able to structure the bonds within the portfolio such that the impact of interest rate movement is minimized, even when we do not know when interest rates will rise. An effective method for mitigating interest rate risk is to create a bond “ladder”. This is a strategy that has one or more bonds come due over a period of years. For example, if you had $100,000, you would have a $10,000 bond come due once a year for ten years. If your ladder is established before a rise in interest rates, you will be getting cash from maturing bonds to re-invest at higher rates as they come due.
Building an effective ladder starts with defining your objectives, structuring the capital allocation within the portfolio, and not concerning yourself with the timing of purchases.
