The stock market is up over 14% since the election, and more aggressive investors have been well rewarded for taking the risk. At the same time, very cautious or skeptical investors may have actually seen slight declines in their investments over this same period of time.
This is primarily due to a fairly substantial increase in longer term interest rates since the election.
For example, the yield on a 10 year U.S. Government bond has gone from approximately 1.4% to over 2.4%, a 70% increase!
The significance of this is that as interest rates rise, many bond values tend to drop. So investors whose portfolios were predominantly allocated in bonds, not only missed the stock market rally, but may have actually taken a small step backwards.
This brings up several questions:
Are interest rates likely to continue to go up?
If so, what impact may this have on bonds?
What are strategies that may work for investors who wish
to remain cautious?
Let’s address the interest rate outlook first. Most economists feel that over the next few years interest rates will more than likely increase. The real issue is how high and how fast. A very sudden increase in rates could have a much bigger negative impact on bond values. A rising interest rate scenario would not affect all bonds the same way. Shorter term or variable rate bonds could hold up much better than longer term ones. The reason is simple, the longer the period before the bond matures, the more risk you are taking that interest rates may continue to rise while you own that bond.
So here’s the cautious investors’ dilemma: Because Interest rates are near historic lows, the temptation is to buy longer term bonds in an attempt to increase investment income. By doing this though, the value of those bonds may drop significantly if interest rates continue to increase, especially if they were to spike quickly.
One popular strategy to address this dilemma is to “ladder” the maturities of the bonds. Instead of buying a single bond for $50,000 with a single interest rate and maturity, you could buy several bonds with differing maturity dates and yields.
For example, you could buy one $10,000 bond that would mature in one year, a second one that would mature in two years, a third at three years and so forth. Each bond would represent a different rung on the ladder. By staggering the maturities you are reducing the risk of rising interest rates, since you have the opportunity to annually reinvest the maturing bonds at the then higher interest rates. While this technique would slightly reduce the interest rate you could earn than if you would have bought a single longer term bond, it would also give you some protection if interest rates were to dramatically rise and you needed to sell the bond before it matured.
In addition, investors can customize their portfolio’s by adjusting the “height” of their ladders (the length of the longest term bonds), the duration difference between each “rung”, and the types of bonds being bought ( government bonds, tax-free bonds, corporate bonds, etc.).
Bond laddering is not for everyone. Most professionals agree that a bond ladder shouldn’t be attempted if investors do not have enough money to fully diversify their portfolio by investing in several types and durations of bonds. The money required to properly diversify a bond ladder that would have at least five rungs would typically be over $150,000. If you don’t have this recommended amount, purchasing products such as bond funds or ETF’s might be more prudent.
In either case, it’s important to work with a professional to make sure that all your eggs aren’t in one basket, so that you can control risk exposure, have greater access to emergency funds and have the opportunity to capitalize on ever-changing market conditions.
If you have questions in regard to using a bond ladder strategy, feel free to give us a call.