If you're a Rim Country fixed-income investor, you'll eventually have to answer a key question: What should you do with bonds that mature when market interest rates are low? You could, of course, reinvest your proceeds in bonds that pay lower interest rates. The down side of this choice is obvious: You'll receive less income. As an alternative, you could put the funds from your maturing bonds in a money market account until rates rise again, but that might take a while -- and, in the meantime, you will have almost certainly missed out on some better opportunities. Here's a third option: Instead of worrying about the haze of interest-rate movements and how you should respond to them, consider an "all-weather" fixed-income investment strategy. Specifically, think about building a "bond ladder."
To create a bond ladder, you invest in an array of short, intermediate and long-term, high-quality bonds. When rates are rising, you use the proceeds from your maturing bonds to buy new bonds at the higher levels, thus increasing your portfolio's return. When market rates are falling, you'll continue to benefit from the higher rates offered by your longer-terms bonds. By building a bond ladder, you'll also receive other key benefits:
- Reduced volatility. When you construct a bond ladder, you achieve a degree of diversification in your fixed-income holdings. And diversification is important because bonds of varying maturities often react differently to interest rate changes and other market conditions.
- Reduced interest-rate and reinvestment risk. Both short-term and long-term bonds carry their own risks. If you own short-terms bonds, you incur "reinvestment risk" -- the risk, described above, of having to reinvest matured bonds at a lower interest rate. And, if you own long-term bonds, you face "interest-rate risk" -- the risk that your bonds could lose value if interest rates rise. But when you build a bond ladder, your mix of bonds can lessen both these types of risk.
- Increased investment discipline. When you create a structured investment plan, such as a bond ladder, you'll help yourself stay true to your long-term goals. With your plan in place, you'll be far less likely to make changes based on short-term stimuli, such as sudden changes in interest rates.
• Income stream suited to your needs. By carefully structuring your bond ladder in a way that generated interest payments that match your needs -- i.e. higher in some months -- you can help address some of your savings and budgetary concerns.
- "Call" protection. When market rates drop, many bond issuers decide to "call" their bonds early. That is, they repay the principal so they can reissue bonds at lower rates. As a bondholder, these calls could work to your disadvantage. But, if you have a diversified bond portfolio, such as that found in a bond ladder, you can build in a variety of call dates, so that you won't be hit all at once with a number of calls. If you knew exactly where rates were heading, you'd always be able to make the right fixed-income investment moves. But since nobody can really "see through the clouds" to accurately predict the direction of interest rates, you're far better off by dropping out of the "guessing game" altogether. Or, better yet, climb out with a bond ladder.