Bonds are an important component of diversified portfolios because they offer investors predictable returns and reliable cash flow without the volatility of the public equity markets. However, this is not to say that bonds are not subject to risks. They are, especially in times of rising interest rates. The good news is you can mitigate some of this interest rate risk by employing a laddering strategy.
As a general rule of finance, bond prices have an inverse relationship with interest rates. This means that as interest rates rise, the value and yield of existing bonds decline as compared to newer bonds. To avoid this scenario, investors may instead create a bond ladder by purchasing a blend of short and long-term bonds that mature at different times over a certain period of years.
The size and structure of a bond ladder depend on an investor’s unique circumstances, including time to retirement, risk tolerance and goals. However, the aim is to have securities that mature every few months or every year. As bonds on the bottom rungs of the ladder mature, investors can reinvest those proceeds into longer-maturity with higher yields on the ladder’s top rungs. If interest rates fall, reinvested proceeds will be at lower rates, but the remaining ladder will still be locked-in and earning higher yields. Should investors need those proceeds, they could use the cash from maturing bonds without the risk of losing any principal.
Raymond James offers the following example of how laddering maturities can minimize 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 percent for every 1 percent 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.
Working with experienced financial advisors can help investors navigate the full realm of investment opportunities available to them and implement strategies designed to minimizing risk and tax liabilities.
About the author: Todd A. Moll, CFP®, CFA, is a director and chief investment officer with Provenance Wealth Advisor, an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email firstname.lastname@example.org.
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Todd A. Moll is a registered representative of and offers securities through Raymond James Financial Services, Inc., Members FINRA/SIPC.
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The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Past performance is not a guarantee of future results.
Every investor’s situation is unique, and you should consider your investment goals, risk tolerance and time horizon before making any investment or withdrawal decision. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices generally rise.
Posted on April 26, 2023