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Building a Bond Ladder
Sunday 22, January 2017

BUILDING A BOND LADDER

Toni-Ann

At the start of every year our clients ask us what to expect for the coming year, and as always I wish we could predict the future. One thing for certain is that 2017 will be an interesting one with a lot of uncertainty surrounding the future of interest rates, the future of the European Union, the Trump Presidency, and the outlook for bonds. Instead of trying to predict the market, it is probably more useful to work with your investment advisor to devise a strategy that will best suit your risk appetite and goals. Bond laddering is popular go-to strategy that could be considered, especially in a rising-interest-rate environment.

Bond laddering is a strategy of creating a portfolio with several fixed-rate bonds whose maturity dates are evenly spaced across several months or years, rather than one large bond with a single maturity date- i.e. a “bullet” strategy. Since there are several bonds with a staggered maturities, bonds are constantly maturing and can be reinvested at regular intervals or used to satisfy liquidity needs on a consistent, scheduled basis.

Based on how it is structured, a bond ladder regularly frees up portions of your portfolio. This is especially appealing in a rising interest rate environment as it allows you to take advantage of the new, higher rates. Each time you get back the principal from a maturing bond you have the opportunity to reinvest it in one that pays a higher rate.

But even if rates have fallen as one “rung” in your ladder approaches maturity, the good news is that, if you choose to reinvest, you will only be reinvesting a fraction of your bond portfolio at the lower rate. Meanwhile, the other bonds in the ladder will continue generating income at the relatively higher older rates. This is a much better scenario than having a single bond or bonds with maturities “bunched up” in one time period, since you may get caught holding a significant cash position if you get back all your principal when reinvesting conditions are less optimal.

While building a bond ladder may help you to manage interest rate and reinvestment risk to some extent, there are a few important guidelines to consider:

  1. Do you have an emergency fund and the right temperament?

Before investing in a bond ladder it is recommended that you have enough money set aside to meet your short-term needs and deal with emergencies and you should also have a temperament that will allow you to ride out the ups and downs of the market. That is because many of the benefits of bond ladder such as scheduled income and managing interest rates are based on the idea that you hold your bonds in your portfolio until they mature. If you sell early, either because of a medical emergency or you change your investment plans you will disrupt your strategy and be exposed to additional risks, including the risks of a capital loss or decreased yield from your ladder.

  1. The right type of bonds

Because one of the main purposes of a bond ladder is to provide consistent income over a long period of time, you need to choose bonds that are a good fit for this strategy.

When a bond is called (redeemed) prior to maturity, its interest payments cease and the principal is returned before you expected it which alters both your cash flow schedule and the schedule of principal coming due. Therefore it is recommended when building a ladder to select bonds that don’t have a call feature.

A worse disruption would be if a bond in your ladder were to default because not only would you lose the income stream but your principal as well! So you may want to consider only higher-quality bonds

Having a well-diversified bond ladder does not guarantee that you will avoid a loss, but it can help protect you the way that any diversified portfolio does, by helping to manage the risk of exposure to any single issuer, country, industry, etc.

  1. Think about time and frequency

 

Another important thing to plan carefully when constructing your ladder is the total length of time the ladder will cover and the number of rungs it needs to have i.e. how often the bonds in the ladder are scheduled to mature. A ladder with more rungs will require a larger investment but will provide a greater range of maturities giving you the flexibility to invest in different credit and interest rate environments. The more liquidity an investor needs, the closer together his bond maturities should be.

Building a bond ladder appeals to many investors, especially retirees, because it can help manage the risks associated with changing interest rates and customize a stream of income. As with any investment strategy, there are advantages and disadvantages, but if you build a strong ladder with the right ‘materials’, using the tips I have shared, this strategy could take your portfolio to the next level (pun intended).

 

Toni-Ann Neita is Assistant Vice President, Personal Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. For more information please visit our website: www.sterling.com.jm  Feedback:  If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm 

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