Climbing the Ladder: How to Manage Risk in Your Bond Portfolio

The stock market crash of October 1987 was highly dramatized in the media. But during that year, more money was lost in long-term bonds and bond funds than in stocks.

Interest rates fluctuated widely throughout the year, then rose dramatically by the end of that year. This caused the bond market to lose significant value.

Why?

When interest rates rise, market values of existing bonds drop because their interest rates are fixed and the present value of the bond's stream of interest payments fluctuates. These factors caused investors to panic and sell their bond funds, leaving fund managers with no choice but to sell these long-term bonds at depressed prices as a way to generate cash for redemptions.

THE RISKS

The 1987 bond market crash dramatically illustrates the market price risk of fixed bonds and bond funds. However, there are actually four main risks inherent in every bond and bond fund:

• Credit risk—the risk that bond issues will not be able to pay the income or principal,

• Income tax risk—the risk that your after-tax will change due to legislation,

• Market price risk—the risk that the value of the bond will change when interest rates change, and

• Reinvestment risk—the risk that you will not be able to reinvest the periodic bond income (coupon) payments and returned principal at maturity at the same rate you are currently receiving from the bond.

It is possible to control credit risk through research and diversification, and income tax risk can be controlled by investing in tax-free bonds or using a tax-deferred account.

But it is impossible to simultaneously master market price risk and reinvestment risk of fixed coupon bonds. That's because there is a trade-off between the two— investments that can reduce market price risk have higher reinvestment risk, and the investments that can reduce reinvestment risk tend to have higher market price risk.

Market price risk, for example, can be reduced by owning a short-term CD or a money market fund because the market price stays constant. However, reinvestment risk is high because upon maturity your money must be reinvested, possibly at lower rates. In addition, yields on short-term bonds are relatively low compared to long-term bonds, so each time you reinvest in short-term bonds, yields tend to be lower than that of longer-term bonds.

Reinvestment risk can be reduced through investing in long-term zero-coupon bonds, because reinvestment of all payments is put off until maturity, but a zero-coupon bond has substantial market price risk.

The best you can do is to strike a balance between reinvestment risk and market price risk.

How, then, can fixed-income investors strike this balance, achieving a respectable rate of return without experiencing the higher risk associated with the fluctuation of interest rates?

THE SOLUTION: LADDERING

Figure 1. Maturities Laddered Over One to 10 Years CLICK ON IMAGE TO SEE FULL SIZE.

Laddering involves building a portfolio of bonds with staggered maturities so that a portion of the portfolio will mature each year. To maintain the ladder, money that comes in from currently maturing bonds is typically invested in bonds with longer maturities within the range of the bond ladder (see Figure 1).

Laddering tends to outperform other bond strategies because it simultaneously accomplishes two goals:

• It captures price appreciation as the bonds age and their remaining life shortens; and

• It reinvests principal from maturing short-term bonds (low-yielding bonds) into new longer-term bonds (high-yielding bonds).

MANAGING MARKET PRICE RISK

The primary goal of a laddered bond portfolio is to achieve a total return over all interest rate cycles that compares favorably to the total return of a long-term bond, but with less market price and reinvestment risk. This is achieved by maintaining an investment of approximately 4% to 10% of a bond portfolio in each year of the selected maturity range. We find that two ranges of ladders provide the best results:

• A limited-term ladder in which the average maturity is kept between three and five years, and

• An intermediate-term ladder with an average maturity of between six and 10 years.

Why use these ranges?

A bond's sensitivity to interest rates is measured by its duration. Duration measures the price sensitivity of a bond relative to interest rate changes. More specifically, duration is the approximate percentage change in price for a low basis point change in interest rates. The shorter the duration, the less volatile the bond's price when interest rates change. For example, when interest rates shift, a bond with a one-year maturity barely budges in price, while the price of a 30-year bond moves dramatically. Long-term bond funds pay a heavy price for their marginally higher yields.

As limited- and intermediate-term bonds mature, their durations shorten at an increasing rate, in a telescoping effect. A single year of "aging" will shorten the duration of a five-year bond more than it does a 10-year bond, and it will benefit a 10-year bond more than a 20-year bond. A 30-year bond's duration, on the other hand, hardly responds to a single year's passing.

Comparing three identical bonds with 5% coupons, the bond with the shorter duration carries less risk, which means a potential buyer will accept less yield (and will therefore pay more). Thus, if interest rates remain constant, the bond will rise in value over most of its life as its duration shortens. If interest rates rise, the bond will recover much, if not all, of its lost value as its duration shortens and it is priced to the lower yield of a shortened bond.

MANAGING REINVESTMENT RISK

Figure 2. Total Return of Laddered Portfolio Under Three Interest Rate Scenarios CLICK ON IMAGE TO SEE FULL SIZE.

In a laddered portfolio, bonds mature every year. As this occurs, the principal proceeds are reinvested at the longer end of the ladder, often at higher interest rates. The income stream will stay relatively constant because only a small portion of the portfolio will mature and be replaced each year. Over time, the portfolio will include bonds purchased in periods of both high and low interest rates.

Here's how the ladder can be expected to react to three interest rate scenarios (see Figure 2).

Unchanged Interest Rates
The centerline in Figure 2 shows unchanged interest rates. In this scenario, a very steady return is generated each year, and the return will be very close to the highest-yielding bond in the portfolio.

Rising Interest Rates
The curved line that starts at the bottom left of Figure 2 illustrates a rising rate environment. In this scenario, bond values will initially drop, but only temporarily. Unlike owning an individual bond, the ladder has maturing bonds each year, which gives the portfolio a stream of cash flow to reinvest in new, cheaper higher-yielding bonds. This creates a consistent pattern of investment, much as dollar-cost averaging does for the equity market. As proceeds from maturing bonds are reinvested in higher-yielding bonds at the far end of the ladder, the portfolio's yield gradually increases.

This built-in reinvestment feature works to offset some of the price depreciation that occurs throughout the ladder when interest rates rise. It also results in a rising income stream. After a few years, the portfolio's total return first equals the return it would have received if rates were unchanged—then surpasses that rate.

Falling Interest Rates
The curved line starting at the upper left in Figure 2 shows what happens to total return when interest rates fall. In this scenario, initially the portfolio's return rises in value as the bonds in the portfolio rise in value. Ultimately, as those bonds mature and proceeds are reinvested in lower-yielding bonds, the portfolio's long-term return is lower than it would have been under the first two scenarios, because the reinvestments are in lower-yielding bonds.

The income stream also decreases, but only gradually because the longer-term higher-yielding bonds continue to be held in the portfolio and the income generated continues to be the average of all the bonds.

SUMMARY

The laddering strategy can reduce interest rate risk because it shortens the average maturity of a portfolio, resulting in less price sensitivity to changing interest rates. The strategy also smoothes out reinvestment risk since money is being reinvested continuously throughout a full interest rate cycle.

The end result is a portfolio with returns close to those of long-term bonds, but with substantially less risk.

As you have seen, it really doesn't matter which way interest rates move. With a laddering strategy, it's possible to get attractive risk adjusted returns. That gives you a competitive advantage: You don't need a particular interest rate environment, or a crystal ball to know where rates are headed, because any time is a good time to build or buy into a laddered portfolio.

It's the smart way to increase the portfolio's return while minimizing both market risk and reinvestment risk.