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Mitigating interest rate risk through bond ‘ladders’

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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.

Frozen in Place

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Frozen in Place:

Bloomberg.com had a very interesting insight this morning on the movement of the S&P 500 for this year-to-date.  As of this morning, the market was up around 2% year-to-date, a mediocre performance in a bull market but deeply disappointing for investors after the double-digit gains of the past few years.  But more interesting is the range of movement in the stock level – a total of 6.5% total movement between the high and low for the year.

Going back at least 20 years this volatility of the major gauge hasn’t been this low.  The “deer in the headlights” action of the market is attributed to the mixed economic indicators and the anticipation of Fed action sometime this year.  If rates go up too fast, it could stall the economy, driving down stocks.  If the Fed does nothing, it might indicate that the data is pointing to already weak economic performance.  Something in between is what the market is looking for, but until that happens we are likely to continue in this “in-between.”

It doesn’t mean to show that volatility is low in general.  To the contrary, currencies, commodities and fixed income have all seen significant gyrations this year, with more to come if there isn’t some clear direction soon.

In my opinion, this pause in the market is a very good thing.  It gives corporate earnings a chance to catch up to stock prices, and sets the groundwork for a strong rally in the fall if we see the economic growth is truly able to take hold for the long term.  The indicators that we continue to look at are employment and housing – two key factors to supporting the consumption-based economy here in the US.  Last month’s employment numbers were impressive, starting to take a bite out of the historically low labor participation rate.  But that trend needs to accelerate to really create liftoff in the economy.

More in our Market Update at the end of the month.