Now’s the time for a bond ladder

Source: MARKETWATCH

But inflation risk is just one challenge investors face

By Robert Powell, MarketWatch

Last Update: 12:01 AM ET Apr 18, 2012

BOSTON (MarketWatch) Given whats likely to happen to interest rates in the coming months and years, now might be the perfect time to use a bond ladder for your portfolio.

Thats according to experts who recently discussed the prospects for fixed-income investments as part of a MarketWatch Investing Insights event in New York.

Bond laddering is a technique for generating current income while reducing the effect of rising and falling interest rates on the fixed-income portion of your portfolio, according to William O'Donnell, the head of U.S. Treasury strategy at RBS.

ODonnell, along with Lee Munson, founder and chief investment officer of Portfolio LLC, were among the panelists.

I look at a bond ladder as a very reasonable and appropriate way to manage your fixed-income portfolio, ODonnell said in a recent interview.

In essence, the technique calls for building a portfolio of fixed-income investments (CDs, annuities, bonds, ETFs, and the like) that mature at different dates along the so-called yield curve the curve that shows interest-rate yields based on maturities based on your outlook for interest rates.

Interest-rate risk versus inflation risk

If you are unsure whether interest rates might rise or fall in the future, you might put your cash in equal amounts in a number of fixed-income investments for example, one-third in short-term bonds, one-third in intermediate-term and one-third in long-term bonds. Then you simply roll the maturing bonds back into short-term fixed-income investments.

If, on the other hand, you think interest rates might fall (you would be alone in that group), you would do the exact opposite and invest a larger percentage of your portfolio in long-term fixed-income investments, and a much smaller percentage in short- and intermediate-term fixed-income investments.

Investing exclusively or largely in long-term fixed-income investments subjects you to interest-rate risk the risk that the value of your bonds will fall should interest rates rise.

So, if you think, as many do today, that interest rates might rise, you would invest a larger percentage of your portfolio in short-term fixed-income investments, say two-thirds, and a smaller percentage in intermediate- and long-term fixed-income investments, say one-third. Then, as fixed-income investments mature, you would reinvest the proceeds in higher earning investments.

Keep in mind, however, that investing exclusively or mostly in short-term fixed-income investments in todays market subjects you to inflation risk. Thats the risk that the value of your investment declines as inflation shrinks your purchasing power. (Right now, youre earning a negative real rate of return on short-term fixed-income investments; the real rate of return is the nominal interest rate minus the rate of inflation.)

With a bond ladder, you are essentially trying to manage many of the risks associated with investing in fixed-income securities, including interest-rate risk, inflation risk, and reinvestment risk. Reinvestment risk is the risk that youll have to reinvest in lower yielding investments when your fixed-income investments mature in a falling interest rate environment.

Fed adds to the risk

Managing those risks is made even more difficult given the Federal Reserve and its efforts to bolster the economy.

The difficulty with the U.S. fixed-income market right now is that it's being heavily manipulated by the Fed and this is all under what the Fed refers to as the portfolio balance channel, ODonnell said. They basically want to push base Treasury rates down to levels that force people to go into riskier asset classes in search of more yield or return.

And it's worked handsomely well, which is why the stock market keeps going up every week, and why Treasurys are unwilling or unable to sell off in the face of stronger economic data, he said.

The Fed is removing the net supply of Treasurys from the market through their quantitative easing, as well as removing duration from the market through Operation Twist, keeping real rates negative in many cases, he said.

Heres the question that fixed-income investors must answer when building their bond ladder: When is the Fed going to remove their guiding hand and let the rate markets normalize? said ODonnell.

For the record, ODonnell doesnt expect the Fed to remove its guiding hand before the end of the year. The Federal Reserve, meanwhile, tipped its hand to the contrary. According to the minutes of its policy meeting in March, members of the Federal Reserve Board are not interested in another round of quantitative easing.

Of course, its even more complicated than all that.

Which bonds?

Besides making the right guess about the direction of interest rates, you have plenty more to consider, including which fixed-income investments work best for you in building a bond ladder. The choices include (but are not limited to) CDs, income annuities, corporate bonds, government bonds, municipal bonds, junk bonds, or mutual funds and/or ETFs that invest in fixed-income securities.

If you plan to purchase individual bonds, consider whether you have enough money to do so. Some experts recommend that you have at least $100,000 to build an adequately diversified portfolio of individual bonds. Also, if you plan on building a bond ladder with individual bonds, you have to consider default risk.

You can reduce the risk of default by building a bond ladder with ETFs or mutual funds. Guggenheim and iShares are among those firms that offer a lineup of target maturity date fixed-income ETFs.

Heres a piece by Matt Tucker, head of iShares fixed-income strategy, explaining how some investors are using ETFs to build a bond ladder.

And heres a link to information about Guggenheims target-date ETFs.

Robert Powell is editor of Retirement Weekly, published by MarketWatch. Follow his tweets at RJPIII.

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