Date: 1/19/2010
Author: John Radtke

Bond Ladders in a Rising Rate Environment

Legendary investor Benjamin Graham wrote in The Intelligent Investor that the proportion of an investor's portfolio held in bonds should never be less than 25% or more than 75%.

If interest rates rise in 2010 and beyond, which bond strategies might work best? Is Ben Graham's rule of thumb still valid?

For fixed income allocations, building bond ladders has stood the test of time – even in rising rate environments.

Bond laddering in its simplest form involves owning a number of bonds that will come due over a period of years (e.g. from 2 to 10 years). When the earliest maturing bond comes due, it's typically replaced with a bond of an equal amount at the longer end of the maturity ladder.

Proponents of laddering say it lowers reinvestment risk and minimizes the guesswork in playing the yield curve. For income-oriented investors, bond laddering is often a 'compromise' solution for maximizing yields while reducing interest rate risk.

Among many advisors, it's assumed that fixed income portfolios of greater than $200,000 can benefit from laddering individual bonds. For smaller portfolios, bond funds and bond ETFs diversify credit risk. And while bond funds & ETFs don't mature, they can in effect be laddered by average duration.

But what if rates move higher? Longer term bonds expose a portfolio to greater volatility and potential losses if sold prior to maturity. Laddering proponents argue that while the total portfolio might generate a below-market return in a rising rate environment, the maturing bonds can be reinvested at higher rates.

Here's one guideline that has worked historically:

  • When the yield curve is flat, allocations should be focused shorter term - often from one to ten years.
  • If the yield curve is ascending and steep (as currently), allocations often are extended to build a five to twenty-year ladder.

Are higher long term bond yields worth the risk? The chart below outlines the sensitivity of total returns for various maturities over a one year holding period, given both rising and falling yields. These hypothetical yields correspond roughly to where many A-rated corporate bonds are currently trading.

Maturity Hypothetical Initial Yield -2% -1% 0% +1% +2%
2-year 2.75% 4.6% 3.7% 2.8% 1.8% 0.8%
5-year 3.75% 11.4% 7.5% 3.8% 0.1% -3.3%
10-year 5.00% 20.6% 12.5% 5.0% -1.9% -8.2%
20-year 5.75% 32.7% 18.1% 5.8% -4.9% 13.9%

The investment products discussed herein contain unique risks, terms, conditions and fees specific to each offering. Depending upon the particular investment product, risks may include, but are not limited to, issuer credit risk, market risk, the performance of an underlying derivative financial instrument, formula or strategy, and foreign currency risks. Return of principal may not be guaranteed and may be subject to credit risk of the issuer or the performance of a derivative instrument, formula or strategy. Additionally, unless otherwise specified in the particular offering documentation, the products discussed herein are not FDIC insured, may lose value, and are not bank guaranteed. You should not purchase an investment product or make an investment recommendation to a customer until you have read the specific offering documentation and understand the specific investment terms, conditions and risks of such investment. A copy of the official statement and other offering information may be found at the SEC’s EDGAR as related to securities offerings. Incapital will also provide copies of the relevant offering statements upon request. Incapital does not offer or sell investment products to individual investors. Investors should consult with their financial professional prior to investing any money in these or other products and carefully review the disclosure statement or other offering documents.

This material may include certain representations, projections and comparisons concerning particular investment products, markets or indices. Such representations, projections and comparisons may not reflect the opinions of Incapital and may not be accurate either now or at a future date. Consequently, you should not rely on such representations, projections, comparisons or other opinions in purchasing an investment product or making a recommendation to a customer. Current and future economic and other market events concerning an investment product or an issuer thereof may cause the information provided herein to be incorrect. Past performance is not indicative of future results and should never be relied upon in making an investment decision or recommendation. This material may not have been authored or officially authorized by Incapital, its employees or an affiliate thereof.