Many investors choose bonds to mitigate market risk through diversification. A well-diversified portfolio of bonds can offset some of the risk that comes with investing in stocks and mutual funds.
But bonds are not without their own set of risks. One way to deal with bond risk is to build a laddered portfolio.
Bonds carry a unique set of risks that investors should consider.
Credit risk refers mostly to corporate bonds and the ability of a company to pay interest throughout the bond’s life as well as the final payment at maturity. Rating agencies give credit quality ratings to companies that issue bonds. A higher rating means a lower risk of default, but also a lower interest rate.
Market price risk refers to the fact that a bond’s market value will change when interest rates change. As interest rates rise, the bond’s current market value will fall, and as interest rates fall, the bond’s current market value will rise. This does not affect the par value—the money received at maturity—but rather the price at which you could sell your bond in the open market.
A bond’s current market price moves inversely with market interest rates because the bond’s coupon rate, which is the value of the periodic payments bondholders receive, is fixed—it is set at the time of issue and does not change, even if market rates rise or fall. The market value of a bond is measured by the present value of the bond’s stream of these interest (or coupon) payments, and the final payment at maturity. As the market rates rise, the present value of these payments falls, causing the current market price to fall. This is a concern if you want to trade bonds in the open market. However, if you hold your bond to maturity, you will receive the full par value as well as all of the coupon payments during the bond’s life.
Reinvestment rate risk is the risk that you will not be able to reinvest the periodic bond coupon payments and the principal amount paid at maturity at the same rate you are currently receiving from the bond. For example, say you invest in a bond that has a coupon rate of 5%, but during the bond’s life market rates fall to 3%. This means you cannot reinvest your periodic interest payments at the original 5% rate, but rather reinvestment would be at the market rate of 3%. Your total return from the bond would be smaller than if you were able to reinvest at the coupon rate of 5%.
Reinvestment risk is the mirror image of market price risk—when interest rates rise, the current market value of your bond falls but you can reinvest coupons at higher rates; conversely, when interest rates fall, the value of your existing bond rises but you are reinvesting coupons at lower rates.
Credit risk can be managed by investing in highly rated bonds or Treasuries—although, as the current market has shown, previously highly rated bonds can quickly degrade.
Striking a balance between market price risk and reinvestment rate risk is more difficult. One approach is to minimize the impact of interest rate changes by buying short-term maturity bonds. However, shorter-term bonds typically pay lower yields. Bonds with long-term maturities receive a higher yield, but with greater degrees of market price risk and reinvestment risk.
Laddering a bond portfolio involves building a portfolio of individual 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 the longest maturities within the range of the bond ladder.
The goal of a laddered bond portfolio is to achieve a total return over the interest rate cycles that compares favorably to the return of a long-term bond, but with less market price risk and reinvestment risk.
For example, if you wanted to create a 10-year ladder, you would invest 10% of your funds into bonds maturing in one, two, three, four, five, six, seven, eight, nine and 10 years.
In year one, when the first bond reaches maturity, you would reset the ladder by putting the money received into a new 10-year bond. As each bond comes due, you would buy more 10-year bonds.
With bonds coming due every year, you can take advantage if rates rise by reinvesting your proceeds from the matured bonds at a higher rate. If rates fall when it is time to reinvest, you will have to buy a bond with a lower return, but the rest of your portfolio would be generating above-market rates.
You can create a laddered portfolio on your own using bonds of varying maturities. Most brokers who trade bonds will also assist in creating these portfolios.
Some brokers, such as Fidelity, offer customers on-line tools that help build a laddered bond portfolio. You can find Fidelity’s ladder-building tool at www.fidelity.com by going to Investment Products, then Income Products.
Depending on the type of bond, you can purchase them at issuance or through the secondary market.
Treasury bonds can be bought directly from the government at www.treasurydirect.gov.
Laddered bond portfolios can be beneficial for any investor looking to bonds for added diversification. Laddering helps mitigate risks associated with investing in bonds and will add diversification to stock or mutual fund portfolios.
Tax rules vary based on the types of bonds in your portfolio. Each year you will pay taxes on income received from the coupon payments from corporate bonds. Any capital gains earned from bond sales prior to maturity are taxable, as are gains from bonds purchased at a discount and held until maturity.
Interest earned on Treasury bonds is exempt from state and local taxes; interest earned on municipal bonds is exempt from the issuing state’s income tax, as well as from federal taxes. Taxes must be paid on the imputed interest from original issue discount and zero-coupon bonds. You will receive a 1099-INT from the bond issuer each year for reporting income on your taxes.
See a tax professional for more detailed information regarding your specific situation.
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 rate risk since money is being reinvested continuously throughout a full interest rate cycle.
In general, bonds tend to have lower yields than stocks or mutual fund investments. They are generally less risky, and therefore offer a lower rate of return.
To hold a laddered portfolio, you must reinvest your proceeds each year into new bonds. You cannot set it and forget it as you would if you invested in a few longer-term bonds. You must be willing to research and find appropriate bonds every year for the ladder to work properly.
Unlike a bond mutual fund portfolio, a portfolio that consists of individual bond holdings is undiversified; credit risk cannot be diversified and is therefore very high. Limiting your individual bond holdings to highly rated corporate bonds does not eliminate this risk—as underscored by the once highly rated bonds of General Motors. On the other hand, limiting your individual bond holdings to U.S. Treasuries would eliminate this risk.
In the July 2004 AAII Journal, Steven Bohlin and George Strickland wrote an article called “Climbing the Ladder: How to Manage Risk in Your Bond Portfolio,” which discusses the pros and cons of laddering a bond portfolio and explains how it works. You can find the article by searching for the title in the Search box on AAII’s home page or by going to www.aaii.com/journal and choosing the July 2004 issue from the drop-down menu.