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This chapter is from the book

Creating a Bond Time Ladder

It is possible for ongoing bond investors to gradually develop a portfolio that ultimately secures yields associated with longer-term bonds although the actual holdings of the portfolio are, on average, more intermediate term in nature. The strategy, which reduces many of the risks associated with bond investment, works like this.

Suppose that interest returns from U.S. government bonds, trading at par (face value), are spread so that 2-year Treasury notes are paying 3.7%; 4-year notes are paying 4.0%; 6-year notes are paying 4.2%; 8-year notes are paying 4.4%; and 10-year notes are paying 4.6%. These were rates actually available during the spring of 2005. You are attracted by the higher yields of the 10-year notes but believe that risks in the bond markets may be high and that it might be more prudent to concentrate your portfolio in the shortest-term area, the 2-year note. However, you would prefer returns that are greater than 3.7%. The issue might be resolved by the creation of a bond ladder.

Your bond ladder, in this case, might consist of the following:

  • 20% of assets are placed into 2-year notes, yielding 3.7%.

  • 20% of assets are placed into 4-year notes, yielding 4.0%.

  • 20% of assets are placed into 6-year notes, yielding 4.2%.

  • 20% of assets are placed into 8-year notes, yielding 4.4%.

  • 20% of assets are placed into 10-year notes, yielding 4.6%.

The average yield for the entire portfolio comes to 4.18%. The average maturity is 6 years.

Year-by-Year Management of the Bond Ladder

You have established a portfolio that provides considerable safety, because of the time diversification that is built in to it. Suppose, for example, that interest rates rise during the first 2 years of ownership. Well, at the end of 2 years, your first set of notes will mature. The original 4-year notes now have 2 years of life left; the original set of 6-year notes now have 4 years of life left in them. The original 10-year notes now have 8 years of life remaining. You redeem your original 2-year notes—now matured, ready to be paid off—and use the proceeds to buy new 10-year bonds. Because interest rates have been rising, you will be able to reinvest to secure higher rates of interest for your new investment than were available when you first established your ladder.

If rates had declined instead, your total portfolio would have increased in value, reflecting the reduction in general interest rates, while you were receiving the higher levels of interest rates that prevailed when you first established the ladder.

Every 2 years, you cash in bonds due for redemption, for which you receive their face value, reinvesting in the new longest-term bonds that are coming out. Gradually, your original 10-year notes become 2-year notes, carrying minimum risk but paying a rate of return more typical of longer-term bonds.

If we assume that at the end of 10 years interest rates stand where they stood when you first established your ladder, your entire portfolio will be yielding 4.6%, the rate paid by the original 10-year note. However, the average maturity of your holdings will have become 6 years. If you go forward, maintaining the bond ladder, your portfolio will continue to produce rates of return associated with longer-term bonds, while it carries risks more associated with intermediate-term bonds.

This is not necessarily the most exciting of investment strategies, but it is a strategy that is relatively simple to follow (certainly so with the help of your brokerage bond department) and is excellent for conservative income investing.

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