As an investor, you need to look back no farther than last year to understand why it’s not a good idea to own only stocks.
In fact, many people buy bonds to lessen the impact of volatility on their investment portfolios.
Yet, just as stock prices move up and down, bond prices also fluctuate, primarily in response to rising and falling interest rates.
These interest-rate movements can wreak havoc on your bond portfolio, unless you can help yourself climb over them with a bond ladder.
Before we examine what goes into a bond ladder, let’s review some bond basics relating to price and interest rates.
Suppose, for example, that you a buy a $1,000 bond that pays 5 percent interest and is scheduled to mature in five years. Each year that you hold your bond, you will receive $50 in interest; at the end of five years, you’ll get your $1,000 back, provided the issuer doesn’t default.
However, if you decide to sell your bond before the five-year period is up, you could get more or less than $1,000 for it.
If market interest rates — the rates paid on newly issued bonds — were to drop to 4 percent, then your higher-paying bond is considered more valuable to investors, so you might be able to sell it for, say, $1,050.
Conversely, should market interest rates rise to 6 percent, nobody will pay you full value for your lower-paying bond, so you would have to sell it at a discount, perhaps for $950.
Because market interest rates constantly rise and fall, the value of your bonds will do likewise. This could be a big problem if you wish to sell bonds before they mature and use the money to buy new bonds.
Keep in mind that if bonds are sold prior to maturity, you can lose principal value.
To help reduce the impact of rate swings, you might want to build a bond ladder.
To do so, you buy several bonds, with varying maturities — short-term, intermediate-term and long-term.
Once you’ve constructed your ladder, you’ll have some advantage in all interest-rate environments. When market rates are low, you’ll still have your longer-term bonds earning higher interest rates. (Typically, longer-term bonds pay the highest rates.) Plus, only a small portion of your bond portfolio (the maturing short-term bonds) will need to be reinvested at the low rate. And when market interest rates are high, you can reinvest the maturing short-term bonds at the higher rates.
You can further diversify your ladder by choosing different types of bonds or even certificates of deposit (CDs), for the different rungs.
This diversification can’t guarantee a profit or protect against a loss, but it may help you reduce the negative effects of a downturn that primarily hits one type of bond.
Here’s one more point to keep in mind: Try to avoid building your ladder with bonds that provide little or no call protection.
When market interest rates fall, bond issuers will often call bonds — that is, they will redeem the bonds before they mature — so they can issue new ones at the lower rates.
You can help reduce the call risk in your bond ladder by purchasing bonds with call protection, which cannot be called before a certain date.
Ladders, by definition, can help you surmount obstacles. And the same is true with bond ladders. If you want to invest in bonds, and help reduce the impact of interest-rate movements, consider building your ladder soon.
Ross Hage is a licensed financial adviser with Edward Jones. For more information, call him at (928) 468-2281.