The investment strategy of laddering maturities attempts to balance and blend the principal stability inherent in shorter-term bonds with the yield advantage available on longer-term securities. The resulting diversification helps to potentially reduce risk, improve returns and allow for reinvestment flexibility, while also providing more liquidity and a predictable cash flow. Additionally, laddering a portfolio of bonds provides a way to partially hedge against rising yields in the future.
A laddered portfolio is structured by purchasing several bonds with differing maturities, for example: three, five, seven and 10 years. As each bond matures, proceeds are reinvested in a new bond at the longer-term end of the ladder, which often is the highest yield within the desired maturity range. If interest rates are rising, the maturing principal can be invested at higher rates. If rates are falling, the reinvestment of proceeds will be at lower rates but the remaining ladder will still be locked in and earning higher yields, helping to potentially smooth out the total return on the portfolio. Bond ladders containing non-callable bonds may be more predictable as the term of investment is fixed and will not change. Some examples of various ladder structures are listed below.
Investors who do not have sufficient funds to build a complete ladder, but can save enough for a rung each year, should begin in the middle and add positions on either side in subsequent years. For long-term investors, systematic investing also provides the ability to take advantage of swings in interest rates.
Barbells are a bond investment strategy similar to laddering, except that purchases are concentrated in the short-term and long-term maturities. This allows the investor to potentially capture high yields from longer maturities in one portion of their portfolio, while using the shorter maturities to minimize risk. Barbells can provide opportunity in both rising and declining interest rate environments: If interest rates decrease, the long end of the barbell provides potential for capital gain, however, you would be reinvesting the proceeds into potentially lower yielding bonds. If interest rates increase, the shorter end of the barbell can be reinvested at the new higher rates, however, the current market value of existing long-term bonds could decline.
The following example demonstrates that laddering maturities is a time-honored strategy that can both lessen interest rate risks and potentially optimize the performance of the overall bond portfolio. The table below compares the historical 2-year CD versus a ladder of CDs that is rolled periodically. This hypothetical portfolio had an approximate duration of 2.5, meaning that it would decline (appreciate) by 2.5% for every 1% move up (down) in interest rates. Please note that FDIC-insured brokered certificates of deposit differ from bank CDs. If an investor chooses to redeem a bank CD prior to the stated maturity, they will pay an interest penalty. With a brokered CD, if the funds are needed prior to maturity, the CD is sold on the secondary market. Proceeds may be more or less than the original investment.
(Source: Raymond James) This example is for illustrative purposes only. Investments involve risk and you may incur a profit or a loss. The analysis would be different if compared to CDs of other maturities.
Interest rates should play a key role in the investment decision-making process. For example, if interest rates are higher than in recent years, investors may decide to invest all of their assets at one time. On the other hand, if interest rates are lower, investors may decide not to invest, anticipating missed opportunities for a greater return should interest rates increase in the future. Although investors cannot control, or even predict interest rates, their financial security may depend on the successful management of them.
Laddering maturities can provide results in any one of three ways:
This time-honored investment technique, in which an investor blends several bonds with differing maturities, provides the benefit of blending higher long-term rates with short-term liquidity. Should interest rates remain unchanged, increase, or even decline, a laddered approach to fixed income investing may help reduce risk, improve yields, provide reinvestment flexibility, and provide shorter-term liquidity.
Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration.
There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices rise.
The author of this material is a trader in the Fixed Income department of Raymond James & Associates (RJ&A), and is not an analyst. Any opinions expressed may differ from opinions expressed by other departments of RJ&A and are subject to change without notice. The data and information contained herein were obtained from sources considered to be reliable, but RJ&A does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJ&A may have positions, long or short, held proprietarily. RJ&A or its affiliates may execute transactions that may not be consistent with the report’s conclusions. RJ&A may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James financial advisor. Past performance is no assurance of future results.
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