Investment Management

Bonds, Part II

How can laddering bonds help to de-risk a portfolio?

Since my last post at the beginning of June, the Fed approved another increase in the federal funds rate – this time for 75 basis points, the largest rate hike in a single meeting since 1994 – making the target range 1.5% to 1.75%. According to CNBC, the Fed “sees the target rate ending the year above 3%.”[1]

Since the beginning of 2022, we have seen an overall upward trend in the treasury par yield curve. This curve, which relates the par yield on a security to its time to maturity, can be used to examine if treasury bonds are a strong investment in current market conditions. As you can see from the chart in Figure 1, displaying rates of 6-month, 1-year, 5-year, 10-year, 20-year and 30-year treasuries from the beginning of January 2022 through June 28, 6-month treasuries are now yielding 2.55%, compared to the unappealing 0.22% they were offering at the beginning of the year and 20-year yields are 3.55% vs. 2.05%. This makes sense because higher interest rates mean higher bond yields. As interest rates have begun increasing this year due to the Fed’s actions as they try to tame inflation, the treasury par yield has trended up – exactly what we would expect with bonds in a rising rate environment.

Figure 1: 2022 Year-to-Date Treasury Par Yield Curve Rates

Source: U.S. Department of the Treasury

I have noted the top three risks associated with bonds in Part I of my three-part bond series as: interest rate (market) risk, reinvestment risk, and credit risk. Just as with other types of investments, we believe there are strategies that may help you minimize some of these risks and achieve your financial goals. In part II, I will outline how utilizing a bond ladder within your portfolio could add protection by helping to mitigate interest rate and reinvestment risk.

What is a Bond Ladder?

A bond ladder is an investment strategy in which you divide your total investment into equal amounts and purchase a series of individual bonds with varying maturity dates. As each bond matures, the proceeds are reinvested with a new bond at the maximum maturity for the strategy — with each bond considered a rung of the ladder. The fundamental concept of a bond ladder is diversification by the maturity date, which spreads risk along the interest rate curve.

The approach is similar to dollar-cost averaging, where the “total amount to be invested is divided across periodic purchases of a target asset in an effort to reduce the impact of volatility on the overall purchase”[2]; however, note that the bond ladder is designed to minimize exposure to interest-rate fluctuations. Laddering bonds can also be equated to tranching[3] into the market – our practice when investing new cash. Since we aren’t market timers and don’t know when a market bottom is happening (or will happen), we invest new money over several periods (tranches) of time to help spread risk and help take the emotion out of investing. We find this often takes advantage of the market’s natural volatility and may result in paying a lower average price per share over time.

Download Bond Ladder Visual

Bond Ladders Can Minimize Interest Rate and Reinvestment Risk

At Balentine, we have identified four building blocks of every portfolio — liquid assets, fixed income, market risk, and private capital — which we believe create a more tangible link between goals, risks, and investments. Within the fixed income building block, one can implement a bond ladder as a volatility buffer. A bond ladder may reduce the reinvestment risk associated with rolling over maturing bonds into similar fixed-income products all at once and may provide a reliable source of income. The change in a bond’s price given a change in interest rates is known as its duration. Laddering bonds means holding bonds of different durations – and it creates diversification by reducing the investment rate risk of an investor’s overall portfolio. We believe bond ladders are beneficial as interest rates rise because investors can benefit from new, higher interest rates as they reinvest proceeds of a matured bond on their ladder. As rates fall, prior laddered holdings may produce more income than could be achieved at the current levels in more newly-purchased bonds, thus producing a more consistent yield over the lifetime of the bond ladder.

How to Implement a Bond ladder

To implement a bond ladder, first, determine the length of time you want to invest and how frequently you want access to the principal. Then, purchase a series of high-quality, investment-grade, noncallable[4] individual bonds that have sequential and increasing maturity dates. As one bond matures, the proceeds will be reinvested with the purchase of a new bond at the maximum maturity for the strategy.

Bond Laddering could be for you if you…

  • want a dependable income stream. A laddered bond portfolio might consist of five $100K bonds that mature each of the next five years. At each bond’s maturity, its proceeds are reinvested into a new bond at the end of the ladder, consistently maintaining the five-year ladder.  By staggering maturity dates, investors avoid getting locked into any one rate, while also creating an income stream.  Since we know the majority of bonds pay interest on a semiannual basis, a monthly income stream could be created (for a bond ladder with at least six rungs) by purchasing individual bonds with staggering maturity dates from their bond portfolio.
  • want to reduce volatility exposure. An investor who purchases one $500K 10-year bond may miss the opportunity to purchase higher-yielding bonds issued during that decade. Purchasing five $100K laddered bonds, like the example above, could help ameliorate losses if rates rise while simultaneously protecting principal at risk.

Debbie Carlson, Financial Journalist for U.S. News writes: “Not only are investors buying at different maturities, they are often buying from different issuers. Because investors have locked in their investments and reinvest at predictable increments, this action can lower volatility and still allow investors to participate in the markets.”[5]

Bond Laddering might not be the right fit if you…

  • want to purchase callable bonds[6]. Ladders provide predictable income over a stable timeline. If callable bonds are used as a part of your ladder and the bonds are called, your principal would be returned to you on the call date instead of at maturity and you would then have to reinvest the proceeds from the called bond much earlier than anticipated, which defeats the intent of the ladder. Predictability and diversification is the name of the game when it comes to bond ladders, so while callable bonds tend to offer a higher rate of return, they don’t fit in with the strategy of laddering bonds.
  • do not feel comfortable holding investments through market highs and lows. Fund managers trying to beat benchmarks do not typically hold all bonds till maturity; therefore, they are unable to guarantee returns. However, holding an individual bond to maturity ensures that an investor will get back their principal plus the stated interest rate. It locks in their price on the purchase date. For a bond ladder to work, we believe you should have a disposition that will allow you to ride the highs and lows of market returns and hold bonds until maturity to maximize the benefits of regular, predictable income and risk management. No one can predict exactly when those highs and lows will occur, so we feel time in the market, not timing the market, is what matters most when laddering bonds. This assumes the bond issuer is creditworthy and does not default on the bonds.

Conclusion

While the idea of a bond ladder is simple, implementing this strategy comes with its own set of challenges and there are several moving parts and factors that should be considered when selecting the timeline of the ladder, types of bonds, etc. If you are considering a laddered bond strategy or if you have questions about anything related to your personal finance situation, check with your relationship manager to ensure you are making educated decisions about your portfolio.

 

Next in Series: Bonds, Part III – Series I Savings Bonds: ‘Inflation-proof’ Security Offering 9.62% Gross Return 
Previous in Series: Bonds, Part I: How Interest Rate Increases Affect the Bonds in Your Portfolio

 

[1] CNBC, Treasury Yields Pull Back Ahead of Key Fed Meeting
[2] Investopedia, What is Dollar-Cost Averaging (DCA)?
[3] tranche is a French word meaning slice or portion
[4] A callable bond, also known as a redeemable bond, is a bond that the issuer may redeem before it reaches the stated maturity date.
[5] U.S. News: How to Build a Bond Ladder
[6] Investopedia, Callable Bond

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