Reducing
Interest Rate Risk with Bond Ladders
When
the Federal Reserve surprised investors and economists by reducing short-term
interest rates to historically low levels, it left little hope that rates would
go anywhere but up.
Although rising interest rates may be a sign of economic improvement, they can
be bad news for bondholders. Bond prices move in the opposite direction of
interest rates. This means that when interest rates rise, outstanding bonds lose
value because new bonds offer higher yields. One strategy for protecting bond
investments from interest rate fluctuations is called “laddering.”1
Setting up a bond ladder involves splitting your investment to buy several
different bonds, each with varying maturity (expiration) dates. For example, to
set up a ten-year bond ladder, you might buy five separate bonds with maturity
dates in one, two, three, five, and ten years, respectively. When the first bond
matures after one year, you would use the principal to buy another bond to keep
the ladder intact.
The benefit of a ladder is that when interest rates are low, only a portion of
your investment goes toward the purchase of a new bond. Conversely, when
interest rates rise, you have cash available to purchase a new bond with a
higher yield. In that way, you never commit your entire investment to a single
long-term bond with a low interest rate.
In the last few years, interest rates have fallen to historic lows. With a bond
ladder, you can help shelter your bond investments against future fluctuations.
1) The principal value of bonds may fluctuate due to market
conditions. If redeemed prior to maturity, bonds may be worth more or less than
their original cost.
© 2003 Emerald Publications
