BOND LADDERS – SIMPLE AND EFFECTIVE
Many investors have a portion of their portfolios invested in bonds. Every time bonds mature, they struggle unnecessarily to decide how to reinvest their cash. In one fell swoop, a bond ladder eliminates trying to guess where interest rates are heading, minimizes risk and maximizes returns.
It’s so simple, it sounds too good to be true. But it’s not. Many clients of Global Asset Management Company in Korea use this simple and effective strategy.
In simplest terms, laddered bonds are staggered with different maturities. Let’s say, for example, that you have $50,000 to invest in bonds. The total sum is divided into equal amounts – whether it’s five $10,000 bonds or ten $5,000 bonds. For our example we’ll use five different maturities.
Each bond would represent a rung on the ladder. The first one might mature in 2 years, the next one 4 years, 6 years, 8 years and 10 years. In two years, when the first bond matures, it would be re-invested for 10 years. Once again, you would have a portfolio of bonds maturing in 2, 4, 6, 8 and 10 years.
Read our article on Profiting from Market Downturns.
WHY BUILD A BOND LADDER?
There are several benefits to this strategy. The first one is that you are always reinvesting your cash at the longer end of your maturity range. Except for rare occasions, the longer the bond, the higher the interest rate. So, you are always investing at the maximum rate. A second benefit is that there is a regular amount of liquidity available in a portfolio.
There is always an investment maturing. A third benefit is simplifying decision making and reducing exposure to interest rate risk. Rather than trying to make a decision about where interest rates are heading and guessing the best maturity, you always reinvest at the furthest end of the bond ladder.
The rationale behind this approach
GAM (Global Asset Management) further explains the rationale behind this approach. Laddered bonds protect investors from interest rate risk. For instance, using our example, if $50,000 was invested in one 5-year bond and interest rates went up, then the investor loses the chance to invest funds at the higher rate.
Selling a bond when interest rates rise results in a capital loss. It’s best to have funds available to invest at the higher rates when they increase. The flip side is that in a declining market, laddered portfolios are always investing in longer maturities where there is the best possible rate.
In addition, because it’s just a portion of one’s bond holdings being reinvested at a given time, one doesn’t get stuck reinvesting a large portion of capital at lower rates. Bond ladders mitigate interest rate fluctuations since there is always an upcoming maturity.
The bond market is much larger
A secondary benefit to bond ladders is the ability they provide to control cash flow. The bond market is much larger than the stock market, and in selecting an assortment of bonds with staggered maturity dates, one can select bonds with coupons paid at different times of the year.
Many government bonds have semiannual coupon payments, which means they pay interest twice a year. This aspect of the strategy is more relevant for retired individuals who depend on their investments for regular cash flow. Still, it can be helpful to have access to cash, and to relatively liquid funds with bonds steadily maturing.
One might want access to cash for a real estate down payment, or have unexpected expenses or suffer a job loss. This is a way to maximize one’s safety net on top of maximizing income.
HOW TO BUILD A BOND LADDER
To build a bond ladder, first envision an actual ladder. Next, apply the asset allocation model from your investment plan to determine the total amount you wish to invest in fixed income ($50,000 from our earlier example). The only other decisions you need to make are the number of rungs on the ladder (5 from our example) and the distance between the rungs (ex. 2 years).
Investors may wish to have funds maturing every year, or even every few months. These decisions are best made with guidance from your Global Asset Management company advisor in Seoul. One the decisions are made the math is simple.
A final consideration is the quality of the building materials. And just like a real ladder, the stronger the materials, the safer the ladder. There are many types of fixed income products, with different levels of risks and rewards. Corporate bonds, government and municipal bonds, treasury bills and bank GICs can all be incorporated.
While it can be tempting to sneak a few higher risk bonds into the ladder to grab a little extra return, remember that your capital is at risk. Stick to bonds with a minimum A-grade. Last, avoid investment products that the issuer can redeems. You’ll end up having to reinvest unnecessarily which incurs costs.
The greatest secret
The greatest secret of all to building wealth is to start. This simple strategy can be applied with equal success to a wealthy retiree and a young student starting out. Equally effective ladders can be built with $1 million bonds and $100 GICs. The concept is the same. For more information contact Global Asset Management Korea and speak with a GAM Investment Advisor.