Using A Ladder To Build A Portfolio
A previous column talked about the low interest rate blues for CD holders. It mentioned that rate of return on a sixmonth CD dropped 27%. It asked if your food and clothing bills also decreased by 27%. The point of the column was that there are some alternatives to CDs, specifically ultra short municipal mutual funds. This week’s column is about another strategy for dealing with the lowinterest rate blues.
"Laddering" allows investors to minimize the interest rate risks associated with shortterm fixed income investments, i.e., CDs. It also works with longterm fixed income investments, more commonly called bonds. A laddering strategy can protect both of these investments from interest rate fluctuations by achieving the following:
• Achieve a high total rate of return by extending the maturities of some of the fixed income investments, and maintain liquidity within the portfolio through shortterm holdings.
• Minimize interest rate reinvestment risk in lower interest rate environments (like we are in now), since the higher rates are "locked in" to the longer maturities.
• Provide the flexibility to reassign shortterm holdings to longterm investments during periods of higher interest rates, in order to lock in those higher rates.
Sounds pretty cool, but how does one "ladder" a portfolio?
Here is an example. Let’s say that you have some investable money (a CD or a bond has matured). Instead of reinvesting the lump sum in one CD, you invest in five CDs. You put 20% of your money in a oneyear CD, 20% in a twoyear CD, 20% in a threeyear CD, 20% in a fouryear CD, and 20% in a fiveyear CD.
What is the result? You will receive interest payments from a blend of rates instead of just one. You will have reduced your interest rate risk, which means you avoid keeping all of your eggs in one basket. You will have periodic maturities that allow you to reinvest at prevailing rates. Additionally, you will benefit by blending high- er longterm rates with shortterm li- quidity.
A laddered portfolio is not just for CDs; it works with any fixed income investment. Examples of fixed income investments are high quality corporate bonds, low or nonrated corporate bonds, i.e., "junk" bonds, government bonds, municipal bonds, and "strips."
Strips are created by the big Wall Street bond houses that clip interestbearing coupons from longterm Treasury bonds. Strips are essentially zero cou-pon bonds, meaning you buy them at a discount to face value, e.g., $4,200 for a $5,000 bond, and you get the full value at maturity with no interest payments in between. Perhaps the best choice among strips is Treasury strips. They are easy to buy and sell, and offer guaranteed returns if you hold them to maturity. Strips are generally purchased at a facevalue minimum of $5,000, though some are sold in smaller de-nominations. Be aware, however, that strips do not pay income; instead they provide a future value.
A basket of municipal bonds provides another tool for laddering. I re-cently saw a group of eight municipal bonds from various states with maturities from three through fifteen years. The lowest yield was 4.5%; the highest was 5.5%, making the average 5%. If you are in the 28% bracket, your aftertax yield on this portfolio would be 6.4%. However, be aware that municipal bonds are not a CD equivalent when it comes to safety. The is-suer, although it is a government or government authority, can default on principal or interest payments, and the market value of the bonds will change with interest rates.
Fixed income investors are always subject to interest rate swings. Right now we are at historically low interest rates. But they won’t always be there. Here are three ways that laddered fixed income portfolios can help an investor succeed in different interest rate environments:
• Interest rates remain constant. The yield of the portfolio will increase each year because investment in longer ma-turities will "average up" the total re-turn.
• Interest rates drop. The portfolio is protected against reinvestment risk because longerterm maturities continue to earn higher rates.
• Interest rates rise. As shorter ma-turities come due, proceeds are rein-vested at new, higher levels, thereby improving portfolio return.