Climbing a Ladder Toward Stability

Looking to build a stable fixed-income portfolio? Consider this bond strategy.
Author:
Publish date:

I've sensed a heightened interest among retail investors about bonds in the past few weeks. This sector can be confusing, and bonds are one of the most misunderstood asset classes.

It's hard enough for most people to keep the basic price-to-yield relationship straight, let alone deal with the new instruments and strategies that have mushroomed over the past few decades. There's now a whole spectrum of ways to assemble a fixed-income portfolio, from super-safe to equity-like risky.

I'll examine some riskier ways to invest in coming weeks for those who have the appetite. However, remember what the traditional goal of bonds has been: to provide a stream of income. A simple, long-term strategy called laddering can help achieve two investment goals: income stability and a stable stream of income to offset riskier investments.

What It Is

Laddering involves setting up a bond portfolio with maturities evenly spaced throughout the yield curve. You can space them every year (or two or three years) from the very short maturities out through 10, 15 or more years, depending on your long-term horizon. When you do this, you're setting up a relatively stable income stream. As your shorter bonds mature, you reinvest them on the long end of the ladder.

Should long-term yields decline, your income will decline much more slowly than if you were invested in, say, just an intermediate-term bond fund. Should long-term yields rise, your income will gradually grow (though not as rapidly as if you were entirely in short bonds) as your shorter maturities roll off and are reinvested at higher yields.

Before you implement this strategy, know that it allows your income to remain relatively stable over a long time horizon. If you implement it, you should leave it alone. Gains and losses are not realized through selling; you simply harvest the income that your bonds produce and reinvest as they mature.

The Dos and Don'ts

Normally, I recommend bond funds for most people. It's hard for individuals to trade bonds other than Treasuries and municipals at levels close to where institutions trade them, and funds also offer diversification benefits. For a laddered strategy, though, individual bonds are the way to go because most funds never mature. (There are, of course, exceptions, such as the American Century Target group.) If bond yields go up and stay up, you'll suffer a permanent loss of principal with a fund. With a ladder of individual bonds, you'll constantly have bonds maturing at par and you'll be able to invest them at a higher rate of return.

A laddered strategy should normally employ high-quality bonds for two reasons. The first is safety. If you're investing in individual bonds, you can't get the credit diversification that you can from a fund. If one of your bonds defaults on its interest payments, your income will take a severe hit. You can definitively point to very few companies and say they won't go bankrupt in the next 10 to 20 years. If you do employ corporate bonds in your strategy, stick to safe ones like

IBM

(IBM) - Get Report

and

General Electric

(GE) - Get Report

and concentrate them at the front end of the ladder.

The second reason to stick with quality is cost. Transaction costs can really eat into the yield that retail buyers can get from their bonds; these costs are minimized for Treasuries, municipals, some agencies and perhaps a few high-quality liquid corporates. Cost is a much more important factor for fixed income than for equities. If your broker allows you to trade with minimal commissions, think about spacing your bonds out every year. If your commissions decline with size, consider buying larger blocks and spacing them every two to three years or so.

Since maintaining a steady income stream is a primary goal of this strategy, avoid callable bonds. Most mortgages are a poor choice for a laddered portfolio because a drop in long-term rates will result in a surge of prepayments. In this scenario, a large amount of your portfolio will be returned to you at par, and then must be reinvested at a lower yield.

A loyal reader reports that she uses CDs in her laddered strategy. She scouts out high-yielding CDs from around the country and puts her money into chunks of under $100,000, so they're covered by FDIC insurance. This is a novel idea for me, because we didn't typically move money in such small pieces in my old job. I wouldn't recommend relying on this strategy entirely, because prepayment penalties and illiquidity among CDs can hamstring you if your financial situation changes. You might instead use these only at the short end of your ladder and buy them in amounts small enough that both your principal and future interest are covered by the $100,000 insurance limit.

By setting up a "set it and forget it" fixed-income portfolio, you can pay more attention to your equity portfolio, where more value is added when you put time into it. Also, the more stable and secure your income stream is, whether from your career or your fixed-income portfolio, the more aggressive you can be on the riskier parts of your portfolio. A ladder isn't right for everyone, but it can provide a platform on which to structure other aspects of your holdings.

Brian Reynolds is a Chartered Financial Analyst who spent more than 16 years as a fixed-income portfolio manager and economist at David L. Babson & Co. in Cambridge, Mass. He currently writes and lectures about investment issues and trades for his own account. At the time of publication, he had no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell. He welcomes feedback at

Brian Reynolds.