In a rising interest rate environment, investors might consider attempting to counter their fixed-income risk by building a bond ladder.
Like many investors, you might be concerned about rising interest rates as the Federal Reserve continues to tighten the screws. Bondholders may see higher rates as a threat because when rates go up, bonds lose value, with longer-term bonds being especially vulnerable. One way to attempt to cope is by building what’s called a “ladder” of bonds with different maturities to help hedge against a rise in interest rates.
Let’s look at short-duration bonds versus long-duration bonds to better understand how a ladder might work in this rising-rate environment.
Short-maturity bonds tend to have low coupon payments, but may provide more price stability than long-term bonds.
Long-maturity bonds tend to have relatively higher coupon payments, but also often come with greater price fluctuations than bonds with short maturities.
A diversified bond ladder can balance the timing of payments and fluctuations in prices caused by changing interest rates. In short, holding some long-term bonds might give a portfolio higher returns, while short-term bonds can provide some stability.
“If you want to prepare for future interest rate rises—and the markets point to the possibility of two more this year alone—one way is to build a bond ladder,” says Perry Guarracino, director of fixed income trading for TD Ameritrade. “You can build it any way you want, so that you have bonds maturing every six months, every year, or every two years. You always have the ability, if something matures, to fill up the back of the ladder to attempt to take advantage of rising rates.”
For instance, if a ladder consists of bonds maturing in one, two, three, four, and five years, when the one-year bond matures in a rising interest rate environment, you could buy a five-year bond at a higher rate and keep the ladder going.
Depending on the construction, a bond ladder might also offer a measure of liquidity because an investor can stagger the maturity dates of the ladder's components so that bonds mature at regular intervals. TD Ameritrade clients can create a bond ladder using the Bond Wizard tool online. The wizard shows you the potential cash flow and maturity schedule of your proposed bond portfolio.
If you’re a self-directed investor who feels comfortable building your own bond ladder, you can take advantage of competitive $1-per-bond transaction fees on secondary fixed-income products when trading through the TD Ameritrade online platform.
If you’d rather have some help, there’s no need to be shy. You can define your fixed-income strategy with the one-to-one guidance of TD Ameritrade Fixed Income Specialists. Their objective recommendations and analysis can help you build a portfolio that matches your income needs. However, the fee structure may differ from the $1-per-bond fee structure for self-directed trades. To speak with a Fixed Income Specialist, call 800-934-4445.
It’s important to remember that there is risk associated with bonds, even when you diversify by building a ladder. Government bonds tend to be less risky than corporate bonds, and usually have a lower interest rate. But there can be different rates even among corporate bonds. This is because of something known as default risk, which happens when an issuer goes out of business and isn’t able to pay back the principal—or make any remaining interest payments—on the bonds they’ve issued. There’s generally a lower risk of default for municipal bonds, but investors should understand and be comfortable with the issuer of the bond. If you're interested in a quick refresher on bonds and other fixed income investments, refer to this primer.
Some of the risk in buying bonds may be mitigated by buying only those that are highly rated. Various agencies like Moody’s and Standard & Poor’s issue, track, and update bond ratings on a regular basis, but they each have their own grading criteria, so investors need to educate themselves first.
There’s also a chance rates could fall, which tends to happen when the economy slows down. However, building a ladder helps hedge against that risk, as well.
“You can always adjust,” Guarracino said. “That’s the beauty of building a ladder. If rates fall, then you might consider reinvesting on the shorter end. You can always adjust your ladder as things mature.”
Bonds can be an integral part of any investment portfolio. Ready to explore? TD Ameritrade clients can use the TD Ameritrade Bond Wizard to discover bonds that meet unique criteria. And for more information on the $1 bond offering, please check the TD Ameritrade Bonds & Fixed Income page.
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