Bonds play two key roles in a portfolio: They provide relatively predictable income, and they offer ballast when stormy stock markets might otherwise capsize a portfolio.
Yet, for bond fund investors, changes in interest rates, whether rising or falling, can bring a different set of worries. When rates are declining, the existing bonds generally become more valuable, but finding new bonds that offer a decent yield becomes more of a challenge. Rising rates are also bittersweet: new bonds will tend to offer higher yields but existing bonds suddenly become less valuable.
One of the best ways to remove interest rate angst is to buy and hold bonds to maturity using a strategy known as a bond ladder. Here’s what you need to know.
What is a Bond?
Simply put, a bond is a promissory note made by an issuer (the borrower) to pay bond investors (the lenders) interest at regular intervals plus principal at maturity. For buy-and-hold investors, bonds are generally pretty simple. As long as the issuer doesn't default, they can count on getting back the money they invested plus the agreed-upon interest, or “coupon.”
Where things get complicated is when bond investors trade in and out of bonds. That’s because there is an inverse relationship between bond prices and interest rates. All things being equal, when interest rates are falling, older bonds that offer a higher yield than newly issued bonds become more valuable on the secondary market.
Of course, the opposite is also true: When interest rates go up, the value of exiting bonds tends to go down because the promised interest rate is lower than that of comparable new bonds. In other words, it is possible to lose money on a bond if you sell it for less than you paid.
The Beauty of Buy and Hold
Although bond prices do fluctuate on the open market, buy-and-hold investors don’t necessarily need to worry about these dynamics, particularly if they own a variety of bonds, hold them until their due date and systematically reinvest the proceeds.
Here’s where bond ladders come in. This strategy entails buying bonds with different maturities – or rungs on a ladder – typically ranging for a few months to a couple of decades. When bonds mature, investors can reinvest that money into a new bond, in which case the process starts all over again.
Investors can construct bond ladders with virtually any kind of bond, including U.S. Treasuries, municipal bonds and corporate bonds, among others. As with any security, there are tradeoffs: Corporate bonds and municipal bonds tend to offer higher yields than U.S. Treasuries, but they also carry more credit risk – the possibility that the issuer will default.
Different Building Blocks
It’s possible to build a bond ladder on your own, but most investors will want to work with a professional to create a bond ladder that spreads credit and interest rate risk across a wide range of bonds.
Every situation is different, but most financial advisors recommend allocating at least $100,000 to a bond ladder consisting of at least 10 individual bonds with different maturities. Investors who plan to buy riskier securities will want to allocate more in order to spread their credit risk across many individual bonds.
Many wealth management firms, offer clients the best of both worlds but constructing customized bond ladders that pool client assets but hold bonds to maturity. Clients typically get better pricing than they would buying bonds on their own, and the peace of mind that every bond on the ladder has been vetted by professionals who understand the nuances of credit risk and interest rate trends.
Bonds play a critical role in creating a diversified portfolio that offers steady income and peace of mind in a wide range of markets. To learn more, ask your Fifth Third Wealth Management advisor about the potential benefits of building a bond ladder in your portfolio.