Bond ladders in a rising rate environment: Too hot to handle?

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.

While interest rate exposure should always be considered, specific portfolio goals typically override guessing the Fed’s next move. For investors in individual bonds, a bond ladder creates a steady stream of cash flows. Especially when timed to meet expected needs, laddering is a strategy which can be customized not only by maturity, but by varying amounts, credit ratings and call features.

New issue bonds often offer an estate feature or death put, typically called the survivor’s option. For estate planning purposes, this feature allows heirs to redeem the bonds at par, subject to certain limitations.

Bond laddering tools are available on several sites, including SIFMA’s investinginbonds.com and Incapital’s internotes.com.

While the yield curve and other factors play a role in bond allocation decisions, bond ladders should continue to be an effective strategy in almost every rate environment.

John Radtke is the president of Incapital LLC, a securities and investment banking firm based in Chicago. Incapital underwrites and distributes fixed income securities and structured notes through over 900 broker-dealers and banks in the US, Europe and Asia.

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