For years, bond yields have been at or near historically low levels. And for years, many observers have expected yields to rise sharply. Yields have bounced up a bit in 2013, but there’s no way of knowing which direction they’ll go from here.
In such an environment, handling a client’s fixed income portfolio can be tricky. One approach is to put some of those dollars into a rolling bond ladder. This offers “temporal diversification,” as Robert Tipp, chief investment strategist for Prudential Fixed Income in Newark, N.J., puts it. “Just as holding different asset classes can decrease investors’ risks,” he says, “having bonds maturing in different years can reduce the chance of bad timing.” A client with a bond maturing in 2013 might not be able to find appealing yields while that client could be pleased to have redemption proceeds to reinvest in, say, 2018 or 2023.
With a bond ladder, a client buys a series of individual bonds with staggered maturity dates. (The concept also can be applied to bank CDs or fixed immediate annuities.) “The extent of a ladder may depend on a client’s outlook for future interest rates,” says Tipp. If interest rates are expected to move sharply higher, the ladder might extend only a few years; if interest rates are expected to fall, it might be better to go longer to lock in the current high yields.
This type of ladder can help to generate relatively high yields and moderate interest-rate risk over the long term. Suppose Flo Grant believes that seven years is a good spot on the yield curve. She might buy X dollars’ worth of bonds maturing in 2014, X dollars in 2015 bonds, in 2016 bonds, etc., out to 2020. When her 2014 bond matures, Flo will keep her rolling ladder intact by reinvesting in bonds maturing in 2021.
This tactic offers annual reinvestment, which provides a hedge against rising rates, while the longer-term bonds typically offer higher current yields than a portfolio of short-term bonds. Holding the bonds until maturity reduces volatility risk and allows some certainty in planning. Ultimately, Flo will have a portfolio of bonds bought at a seven-year maturity, where yields may be significant, yet she will have annual reinvestment opportunities.
Tipp says that many clients will be better-served by bond funds, considering the high transaction costs of individual issues and the wider diversification that funds can offer. However, financial planners may be able to reduce those disadvantages, he notes. Clients could be captive to a limited slate of offerings, and reliant on the advisor’s research for selection and monitoring, Tipp concludes, but the advantages include gaining control of their expected maturity schedule by buying individual bonds and having no management fee to pay.