Climbing the ladder to successful bond investing
Diversifying your portfolio, generating income and possibly adding some stability to your holdings are just a few of the many reasons to invest in bonds. But choosing the best bond investment strategy can sometimes be a bit tricky. Whether you are a seasoned fixed-income investor or have never bought a bond, a laddering strategy can help reduce volatility and avoid concentrating reinvestment risk in your portfolio.
First, let’s look at how bonds work. When you purchase a bond you essentially make a loan to the government or a company, called the issuer. In return, the issuer pays you interest on your money. Then, when the bond reaches maturity, the issuer repays you the face value, or principal amount of the bond. Now that you have the essentials, let’s look at a strategy you can possibly apply to your own portfolio.
To begin a bond laddering strategy, you purchase equal dollar amounts of bonds with different maturities. For example, let’s assume you have $50,000 to invest. You can create a laddered portfolio by investing $10,000 each in bonds that would mature in 2006, 2008, 2010, 2012 and 2014.
When the first bond reaches maturity in 2006, you would take the principal that you receive, which is typically the face or maturity value of the bond ($10,000) and reinvest it in bonds that mature in 2016. You would continue this system of reinvestment each time your bonds come due.
A strategy that concentrates in a narrow maturity range might force an investor to reinvest into a very low interest rate environment. In contrast, a laddering strategy lets you reinvest gradually, maintaining a portfolio of bonds earning different interest rates. Let’s say the first bond you invested in has reached maturity and it is time to reinvest the principal. If market interest rates are currently higher than the coupon on the maturing bond, you will probably be able to reinvest the principal at a higher rate of interest. Conversely, if interest rates are lower, you most likely still have a significant portion of your bond portfolio – those that have not yet matured – invested at higher coupon rates.
The interest or coupon rates associated with bonds are important because one of the main reasons many people invest in them is to generate income. Most bonds pay interest semiannually, so in the example above you could select bonds that made payments in different months of the year. This would provide you with steady income throughout the year that could cover living expenses.
Bonds can be a good choice for providing diversity and adding income to your portfolio. If you are looking for a simple and systematic approach to investing in them, you might want to think about using a laddering strategy. Talk to your financial consultant about risks associated with investing in bonds and see if they might be a good addition to your investment mix. nhbr
John Pemble is a financial consultant with A. G. Edwards & Sons’ Nashua office. For more information, call 883-6700.