Income investors are naturally drawn to bonds. After all, they provide guaranteed income for minimal risk.
However, bonds can be problematic when yields are expected to rise.
At the moment, short-term bonds yield almost nothing – but if yields rise, long-term bonds decline in price, leaving investors with a capital loss.
So what should bond investors do?
Fortunately, there’s a way to mitigate interest rate risk with a technique called bond laddering. Even for individual investors who may be relying on investment income for their retirement, it’s a technique worth considering.
In the simplest form of bond laddering, an investor divides his capital into a number of equal tranches – let’s say five – and invests each tranche in Treasury notes maturing in successive years. At present, the 1-year Treasury yields 0.24%, the 2-year yields 0.66%, the 3-year yields 0.94%, the 4-year yields 1.18%, and the 5-year yields 1.43%.
Thus, by investing an equal amount in bonds maturing in each of the next five years, an investor will get an average yield in the first year of 0.89%. Not very exciting, I agree. However, it gets better as you go on.
Once the 1-year bond matures, you reinvest it in a new 5-year bond at 1.43%. Now, while still owning bonds with maturities of one through five years, you’re getting a yield of 1.13%.
As future bonds mature and are replaced with new 5-year bonds, your yield will continue to rise. In five years’ time, if interest rates remain constant, you’ll be receiving a five-year yield of 1.43% on bonds with an average maturity of three years.
Laddering also provides an advantage when interest rates rise.
If rates have risen by 1% in a year’s time, then your maturing 1-year bond will be reinvested in a new 5-year bond at 2.43%, boosting the overall average yield to 1.33%.
Of course, laddering doesn’t enable you to get the full benefit of interest rate rises immediately. But it does give you reinvestment cash each year while minimizing the principal risk from investing in longer-term bonds during a period of rising interest rates.