Jacob’s Bond Ladder

We continue our series about modern alternative and modern traditional investments. Today our subject is a modern traditional investment, bond ladders.

Bonds are traditional investments. They satisfy the modern traditional investment standard when investors create a bond ladder by structuring bond maturities and other terms to manage risk and yields. If bonds are new to you, please take about two minutes to read the “Bond Background” at the bottom of the page.

The Biblical account of Jacob’s ladder[1]describes a gateway to heaven. The ladder inspired Jacob during a journey he took to escape danger. A bond ladder[2]offers an escape from danger imposed by investment risk and an inspiring way to earn higher yields.

 

BOND LADDER CONSTRUCTION AND PROCESS

A bond ladder consists of two or more bonds with different maturity dates. Ideally, bonds assume approximately equal values and maturity intervals like the rungs of a ladder. For example, with $60,000 an investor could buy six different bond issues and ten of each issue worth $10,000. Bond maturities could be spaced at one-year intervals.

With this structure, a bond would mature every year. With each maturity, the investor would purchase a new bond maturing one year after the bond with the longest maturity. For example, the original six-bond portfolio would consist of a bond maturing in one year, two years, three years, and so on. When the one-year bond matures, the original six-year bond will mature in five years.  Proceeds from the first maturity fund a new six-year bond.

 

WHY BOND LADDERS ARE SO SPECIAL

Ladders provide liquidity.[3]Even though the ladder in the example has a three-year average maturity, one-sixth of the portfolio converts to cash every year. Ordinarily, investors would invest in a new bond, but periodic maturities give them a choice to use bond proceeds for some other purpose. Greater liquidity comes from more closely spaced maturities.

Ladders can help limit interest rate risk. Longer maturities generally lead to greater price fluctuation in response to prevailing interest rate changes.[4]As long as investors hold bonds to maturity, however, they enjoy guarantees of timely interest and principal payments backed by issuers’ cash flows and assets.  If bond prices fluctuate before maturity, investors lose nothing because they know when and how much interest and principal to expect. Also, by periodically replacing bonds – every year in the example – investors can reinvest at prevailing interest rates. The shorter the interval between maturities, the better the bond ladder remains invested at prevailing rates.

Ladders encourage broad allocation. In the interest of satisfying the “don’t put all your eggs in one basket” adage, each bond in the ladder should differ by more than maturity.[5]Bond selection should include issuers in different industries and geographical regions. Other ways to allocate include selecting both government and corporate issues, bonds with special features like interest rate “step-ups,” and inflation-protected bonds.

Ladders can help deliver steady income. Income investors appreciate periodic income because their expenses are also periodic. Since most bonds pay coupons once every six months, a six-bond ladder could be constructed so investors receive coupon payments every month.[6]

Reinvestment can produce above-average returns. When a bond matures, the investor should reinvest by purchasing a bond with a longer maturity than other bonds in the ladder. This practice is based on the normal yield curve[7]in which longer maturities offer higher yields. As the bond ladder ages, even bonds with short maturities could offer yields equal to yields of the longest bonds in the portfolio.

Consider the big picture of managing an investment portfolio: Combined with other non-correlated assets like direct participation oil & gas or direct participation real estate, bond ladders offer potential to deliver regular income, preserve value, and help diversify the portfolio.

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BOND BACKGROUND

  • Bonds are loans investors make to corporations and governments, called issuers. Bond issuers usually[8]pay interest – coupons – every six months and repay principal – the amount borrowed – upon maturity. Maturity is the date the loan agreement ends. Consumer loans are different mainly because consumers usually pay both interest and principal every month.
  • Issuers usually get $1,000 for each bond – par – and pay a fixed coupon rate at six-month intervals with half of the coupon rate paid twice per year. When investors buy bonds in the secondary market after the original issue, they might pay more or less than $1,000 depending on interest rates and other factors. Issuers continue paying the fixed coupon rate until maturity.
  • Bonds paying fixed coupon rates lose market value when prevailing interest rates rise. Here’s why: You own a bond maturing in five years with a 4% coupon. For whatever reason, U.S. interest rates increase so investors buying bonds like yours expect 5%. Who wants to buy your bond if it only pays 4%? Nobody. To compensate prospective buyers, the 4% bond’s price must drop. This is interest rate risk, and it is where “yield” comes in play.
  • “Yield” is the total rate of return an investor earns if a bond is held to maturity. It is “total” return because it includes both bond price and coupon, the only two sources of bond income.

[1]Genesis 28: 10-17. Retrieved from https://www.biblegateway.com/passage/?search=genesis+28%3A10-17&version=NIV.

[2]Text “ladder” to 555888 for more detailed information about bond ladders.

[3]Carey, M. (2018 September 4). 2018 guide to bond, CD, and annuity laddering. Forbes.

Retrieved from https://www.forbes.com/sites/mattcarey/2018/09/04/2018-guide-to-bond-cd-and-annuity-laddering/#6d61d5ae2d00.

[4]The more precise measure of bond sensitivity to interest rate changes is bond duration. Bond duration, expressed in years like maturities, measures the amount of time a bond’s discounted interest and principal payments take to pay in full. Larger duration values indicate greater sensitivity to interest rate changes. This FINRA reference introduces the duration concept: https://www.finra.org/investors/alerts/duration-what-interest-rate-hike-could-do-your-bond-portfolio. This Wolfram reference illustrates bond duration calculation: https://www.wolframalpha.com/input/?i=bond+duration.

[5]Hancock, P. (2015 January 6). 3 key elements of a diversified bond portfolio.JPMorgan Asset Management. Retrieved from https://am.jpmorgan.com/us/en/asset-management/gim/adv/insights/market-insights/3-key-elements-diversified-bond-portfolio.

[6]This income idea works by selecting high quality bonds with other attributes which also pay coupons (interest) in complementary months. Most corporate fixed income bonds pay twice per year at six-month intervals. For a six-bond portfolio it would look like this: Bond 1 pays interest in January and July, Bond 2 pays interest in February and August, Bond 3 pays interest in March and September, Bond 4 pays interest in April and October, Bond 5 pays interest in May and November, and Bond 6 pays interest in June and December. Of course, to satisfy the ladder, the bonds’ maturities must be staggered.

[7]As of this writing, a large part of the yield curve is inverted because yields on maturities less than one year exceed yields on the ten-year Treasury note. However, the normal yield curve has longer maturities with longer yields. -.

[8]The “usual” bond has many exceptions.

 

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