As the Federal Reserve (Fed) gradually raises interest rates, it is reasonable for investors to question the role of bonds in their portfolio. In general, when interest rates rise, bond prices fall, and you may be tempted to move out of bonds. However, we believe it is possible to benefit from the income potential and diversification advantages of bonds, while also protecting your portfolio from rising rates. A bond ladder is one of the most effective tools fixed-income investors can utilize.
What is a bond ladder?
A bond ladder is a portfolio if individual bonds with staggered maturities so that a portion of the portfolio comes due each year. Unlike mutual funds, individual bonds have set maturity dates when investor are scheduled to receive their principal back. Bonds generally mature at par, or $1,000 per bond, regardless of how interest rates change. When the bonds with the shortest maturity dates mature, the cash can be reinvested in new bonds with longer maturities. This can actually be an advantage in a rising rate environment, since periodically maturing bonds are reinvested at potentially higher rates.
The table below shows a sample 6-year bond ladder. After the first year, cash from the 1-year bond due in 2018 is reinvested in a new bond due in 2024.
A major benefit of bond ladders is that it really doesn’t matter which way interest rates move. With a laddering strategy, it’s possible to get consistent returns. This gives laddering investors a competitive advantage, knowing any time is a good time to build or buy a laddered portfolio.
Laddering tends to outperform other bond strategies because it accomplishes 2 goals:
- Captures price appreciation as the bonds age & their remaining life shortens
- Reinvests principal from maturing short-term bonds (low yielding) into longer-term bonds (higher yielding).
Ladders are particularly effective for protecting investors from rising rates. When rates go up, investors may invest money at these higher rates as short bonds mature. In fact, long-term investors in bonds should welcome higher rates. We believe it is compelling to continue to invest in fixed income and rebalance to long-term allocations when rates are rising.
Some other advantages of a professionally managed portfolio of individual bonds:
- Access to Expertise – Signet clients benefit from the experience & knowledge of professional managers in strategy selection & portfolio construction.
- Access to Research – We have access to a wealth of institutional research perspectives on the overall economy, the fixed income markets, and individual bond issues.
- Active Management – Ongoing supervision of your bond portfolio by professional managers empowered to make changes in response to shifts in market conditions.
- Set Maturity Dates – Unlike bond mutual funds, individual bonds have maturity dates. As time passes & and the maturity date approaches, your bonds become less risky.
- Predictable cash flow – Signet offers flexibility to customize cash flows to individual needs.
In this very uncertain environment, we think bond ladders remain effective in a variety of interest rate cycles. Using bond ladders as a component of diversified portfolios has helped us to navigate evolving market conditions, regardless of the direction of interest rates. Even if the Fed continues raising rates, we believe a good advisor can use bond ladders to mitigate downside equity risk & diversify portfolios through good and bad market cycles. This is why we feel confident in the strategy as we look ahead.
The information and opinions included in this document are for background purposes only, are not intended to be full or complete, and should not be viewed as an indication of future results. The information sources used in this letter are: Jeremy Siegel, PhD (Jeremysiegel.com), Goldman Sachs, JP Morgan, Empirical Research Partners, Value Line, Ned Davis Research, Citi research and Nuveen.