Rising Interest Rates? Do This NOW
Dear Rich Lifer,
What’s the safest way to own bonds when interest rates go up?
That’s the question on a lot of investors’ minds right now. According to the Fed, we’ll likely see interest rates rise this year and next.
For bond investors, this is their worst nightmare finally coming true.
So how can you manage your portfolio in a rising interest rate environment?
Today we explain one strategy bond investors have been using for years to manage portfolio risk.
Whether we’re headed for a bear market in bonds or not, this strategy has the potential to deliver consistent cash flow while minimizing your risk…
The Fed’s Dual Mandate
Before we get into the details, let’s look at why interest rates are rising.
Back in 2018, the yield on the 10-year Treasury Bond eclipsed 3% for the first time since 2014.
When this happened, alarm bells sounded because this meant the Fed would soon have to start hiking their benchmark rate more quickly to keep inflation around their 2% target.
At the time, U.S. unemployment was at its lowest level since 2000. Keeping unemployment low is one-half of the Fed’s “dual mandate,” so, as the job market returns to health as the Covid-19 pandemic retreats, central bankers can focus on their other goal – reining in inflation.
As yields on newly-issued debt increase, demand for older, lower-yielding debt decreases. This drives down the price of existing bonds and causes the bear market in bonds we talked about earlier.
If you’re invested in bonds or bond ETFs, this is an especially dangerous time. For example, a popular bond fund is the Vanguard Intermediate-Term Corporate Bond ETF (VCIT), which matures in five to 10 years.
When bonds have less than five years to maturity, Vanguard sells them to extend the portfolio. This means they’re forced to regularly unload bonds at the shorter end of the yield curve while buying bonds at the longer end of the curve. This situation is known as yield-curve risk, and in a rising-rate environment, will slowly drive down the value of the fund.
How to Avoid Yield-Curve Risk
The easiest way to lower your risk is to buy shorter-duration bonds. Bonds that mature in one to five years are less sensitive to interest-rate changes.
The tradeoff, however, is lower yields. Luckily, there’s another way you can limit yield-curve risk and lock in steady cash flow that rises as benchmark rates go up.
What Are Bond Ladders
Bond ladders are simply a series of bonds or bond funds with staggered maturity dates. The reason bond ladder strategies are so popular is they offer two major benefits to investors:
First, by staggering the maturity dates you won’t be locked into one bond for a long time. A problem with locking yourself into a bond for a long period of time is you can’t protect yourself from bullish and bearish bond markets.
Second, bond ladders allow investors to adjust cash flow according to their needs by guaranteeing monthly income based on the coupon payments from the laddered bonds.
This is critical for retirees who depend on cash flow from investments as a main source of income. And even if you’re not dependent on the income, you’ll still have access to relatively liquid money by having steadily maturing bonds.
If you were to lose your job or an unexpected expense arises, then you’ll have a steady source of cash coming in as needed.
How to Build a Bond Ladder
Building a bond ladder is fairly straightforward: Buy a series of bonds with staggered maturity dates, as each security matures, you reinvest the returns in a new bond at the top of the ladder, which becomes your new longest-dated security.
If interest rates go up, the new bonds will have higher coupon rates than the bonds rolling off the bottom of the ladder, and your yield will rise.
Even though longer-term bonds yield more, shorter-term bonds carry less interest-rate risk. So, if you think rates are going up soon, your longest-dated bond should still mature fairly quickly, think less than five years. This way, you’re not holding a bunch of low-yielding bonds for a long time.
How this might look in practice…
Let’s assume you have $100,000 to invest. To create a bond ladder, you could invest $20,000 in a one-year bond at 1%, $20,000 in a two-year bond at 1.25%, and $20,000 in a three-year bond at 2.00%, and so on up to five years. Each year is considered a “rung” on the ladder.
When the one-year bond matures, you would reinvest the proceeds in a new five-year bond. And repeat this process indefinitely.
Before you go build your bond ladder, there are some drawbacks to laddering you should know.
First, the transaction costs of buying multiple bonds can be higher than buying one large bond. Second, there’s some reinvestment risk due to the nature of the constant maturing of bonds should interest rates start to fall.
Overall, these risks can be managed with a solid bond laddering strategy.
The pros of bond ladders often outweigh the cons. A well-set-up bond ladder can add balance and discipline to your investment portfolio and as long as rates rise over time, a bond ladder will ensure you have capital to reinvest at higher rates.
To a Richer Life,
The Rich Life Roadmap Team