As an investor, you need to look back no further than 2008 to understand why it’s not a good idea to own only stocks. In fact, many people buy bonds to lessen the impact of volatility on their investment portfolios. Yet, just as stock prices move up and down, bond prices also fluctuate, primarily in response to rising and falling interest rates. These interest-rate movements can wreak havoc on your bond portfolio unless you can help yourself climb over them with a “bond ladder.”
Before we examine what goes into a bond ladder, let’s review bond basics relating to price and interest rates. Suppose, for example, that you a buy a $1,000 bond that pays 5% interest and is scheduled to mature in 5 years. Each year you hold your bond, you will receive $50 in interest. At the end of 5 years, you’ll get your $1,000 back, provided the issuer doesn’t default. However, if you decide to sell your bond before the 5 year period is up, you could get more or less than $1,000 for it. If market interest rates — the rates paid on newly issued bonds — were to drop to 4% percent, then your higher-paying bond is considered more valuable to investors, so you might be able to sell it for more.
Conversely, should market interest rates rise to 6%, nobody will pay you full value for your lower-paying bond, so you would have to sell it at a discount or less than you originally paid for it.
Because market interest rates constantly rise and fall, the value of your bonds will also. This fluctuation could be a problem if you wish to sell bonds before they mature and use the money to buy new bonds. Keep in mind that if bonds are sold prior to maturity, you can lose principal value.
To help reduce the impact of rate swings, you might want to build a bond ladder. To do so, you buy several bonds, with varying maturities — short-term, intermediate-term and long-term. Once you’ve constructed your ladder, you’ll have some advantage in all interest-rate environments. When market rates are low, you’ll still have your longer-term bonds earning higher interest rates. (Typically, longer-term bonds pay the highest rates.) Plus, only a small portion of your bond portfolio (the maturing short-term bonds) will need to be reinvested at the low rate. And when market interest rates are high, you can reinvest the maturing short-term bonds at the higher rates.
If you want to invest in bonds, and help reduce the impact of interest-rate movements, consider building your ladder soon. To make an appointment with a Financial Consultant at Founders Investment Services, please call 1-866-739-7064.
Securities and investment advisory services offered through Financial Network Investment Corporation, member SIPC - Founders Federal Credit Union, Founders Financial Group, LLC and Founders Insurance Services are not affiliated with Financial Network Investment Corporation. Financial Network Registered Sales Branches are located at 607 N. Main Street, Lancaster, SC 29720; 1290 Old Springdale Road, Rock Hill, SC 29730; 100 Springcrest Drive, Fort Mill, SC 29715; 1307 Boiling Springs Road, Spartanburg, SC 29303.
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This article was published in the Founders FCU's Springtimers Times Newsletter (June 2010). It was written by Keith Benton, Certified Financial Planner with Founders Investment Services Team.