Climb a Bond Ladder as Interest Rates Rise
By Rick Imhoff, CFP ®
For bond and Certificate of Deposit investors, today’s rising interest rates are both good and bad news. One strategy many financial planners and investment managers have long recommended for handling rising interest rates is the bond ladder.
To understand why a bond ladder works, think of a seesaw. When interest rates rise, the value or price of a bond falls below its par or face value, assuming the current owner bought it new. That’s because other investors are not willing to pay the face value of the bond when they can invest the same amount of money in a similar new bond paying higher interest.
The reverse happens in a falling interest rate environment. Investors are willing to pay more for an existing bond that has not reached its maturity to hang on to the higher rate. The longer the maturity of a bond, the faster the price of the bond falls or rises in relationship to changing interest rates. Of course, if you hold on to individual bonds until they mature, you should receive their face value regardless of any price changes during the holding period.
That is why rising interest rates are both good and bad news for investors. On the one hand, they like the idea of earning more interest on their bonds, especially in the wake of such low rates for so many years.
But that is where the bad news comes in. Investors are reluctant to buy anything but short-term bonds and CDs because they don’t want their money tied up long term should interest rates continue to rise. They also don’t want to risk being in longer-term bonds and watching the prices be punished should rates climb. Of course, the price of a CD you already own will not change when general interest rates change.
Yet longer-term securities usually pay more interest than short-term securities. That is where the bond ladder can help, because it reduces the risk of interest rate changes while allowing you to take advantage of higher rates. Here is how it works.
You buy individual bonds or CDs with a mix of maturities. For example, you might buy roughly equal dollar amounts of various bonds or CDs, with each maturity date representing a different rung on the ladder. When the shortest-term bond or CD matures on the bottom rung of the ladder, reinvest the proceeds in the best-returning rung, which usually is the top rung of bonds or CDs with the longest maturity. In time, the short-maturity, lower-paying rungs will be gradually replaced by higher-paying, longer-maturity bonds or CDs.
Why not just buy the higher-paying, longest-maturity bonds or CDs in the first place? Because by using the ladder approach you always have some bonds or CDs maturing every few months or every year, depending on how you construct your ladder. This enables you to reinvest matured bonds or CDs at the highest available rate, or cash them in without risk of loss of principal should you need the funds.
You can build ladders out of most types of fixed-income securities, such as Treasuries, corporate bonds, CDs, or municipal bonds, depending on what is appropriate for you and what level of risk you are willing to take. You can also build your ladder only as far out in maturity as you feel comfortable or that you need. Perhaps you only want to go out three to five years instead of seven or longer.
If you don’t have enough to invest in a ladder of individual fixed-income securities, it is possible, but more difficult, to build a ladder out of bond mutual funds or exchange traded funds. The problem with funds is that they usually have no definite maturity date and individual investors cannot control redemptions. However, some funds focus on bonds with certain maturities, such as ultra-short, short, intermediate, or long-term bonds, so you could build a rough version of a bond ladder.
Rick Imhoff, CFP®, is Executive Vice President & Senior Trust Officer for MidAmerica National Bank. He can be reached at 309-647-5000, ext. 1130 or by email.
Investments are not FDIC-insured, hold no bank guarantee, may lose value, are not a deposit, and are not insured by any federal government agency.