Rethinking Bonds in a Rising Rate Environment
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As creatures of habit, humans naturally hold on to strategies that have worked well in the past – including investment strategies. For more than three decades, laddering bonds has been a widely used strategy. But changing times call for reconsidering investment strategies.
Essentially, the laddering strategy creates a series of bonds with different maturities. Usually, the bonds mature over a stretch of 10-20 years. Bonds have many risks that are often overlooked. Laddering helps reduce some of those risks.
Under the laddering concept, bondholders have coupons coming in annually from the bond collection. Remember, bonds do not pay interest. Bonds pay a fixed income stream that doesn’t vary unless the bond goes into default. TIPS (Treasury inflation-protected securities) are the notable exception and income varies according to inflation or deflation. When a bond matures, bondholders take the principle they need and purchase another bond that typically matures in 10 to 20 years.
Whether a ladder strategy is used or not, bonds endure credit risk. As long as the company or municipality that issued the bond doesn’t default, the income stream will not change. However, a bond may be priced at a premium (more than the face amount) or a discount (less than the face amount) over its life.
A ladder strategy is used to address the biggest income stream risks related to bonds. Interest rate risk refers to times when current interest rates are higher than the price at which the bond was initially issued. Bonds do have a fixed coupon payment, but the coupon is established based on prevailing rates for a particular time and credit risk. When interest rates rise above the rate on an existing bond, the bond’s value on paper goes down. Conversely, if rates go up, the bond’s value on paper increases.
Please note that bond statement values are not like values on stocks. Stock valuation is based on the last agreed transaction price between a willing seller and buyer. Bond pricing more closely resembles a home appraisal. The premium or discount is established based on mathematical calculations for future income streams relative to the current market. Just because a bond statement says it happens to be worth more – trading at a premium – doesn’t necessarily mean bondholders can sell at that price.
The biggest reason for the bond ladder strategy relates to reinvestment rate risk. When the bond comes due, bondholders get cash and must buy at the current rate. A bond issued 20 years ago might have a 7% coupon or more. Reinvested today, the holders might get 4-5% for the same credit risk.
People who say bonds aren’t risky don’t understand the factors involved in a rising interest rate world. For the last 38 years, we have been in a bullish bond market. Our concern is that investors who don’t understand today’s dynamics affecting bonds will continue to employ a once useful strategy that is now very broken.
Joseph Clark is a Certified Financial PlannerTM and the Managing Partner of Financial Enhancement Group, LLC an SEC registered Investment Advisor. He is the host of “Consider This” found on 98.7 The Song and WIBC Saturday mornings as well as three other Indiana-based radio stations. Joe has served as an Adjunct Assistant Professor at Purdue University where he taught the capstone course for a degree in Financial Counseling and Planning. Securities offered through World Equity Group, Inc., member FINRA/SIPC, a broker dealer and SEC registered Investment Advisor. Advisory Services can be provided by Financial Enhancement Group (FEG) or World Equity Group. FEG and World Equity Group are separately owned and operated and are not affiliated. Joe can be reached at firstname.lastname@example.org, or (765) 640-1524.