How To Ladder Bonds For Less Risk

- Alan Lavine and Gail Liberman

The economy is picking up steam. Uncle Sam is running a monumental government deficit and the dollar is falling. In the past, that has been a prescription for higher interest rates. The Fed has not raised rates yet. But many expect higher rates in 2004.

George Strickland, managing director at Thornburg Investment Management, Santa Fe, N.M., says that when you invest in bonds, it's best to create a bond ladder.

In other words, you typically buy a series of bonds ranging from short-term bonds that mature in one-to-two years and three-to-four years at the lower levels, on up to eight-to-10 years or longer at the upper levels. By buying different maturities, you have money maturing each year to reinvest in new higher-yielding bonds.

For example, if your money were laddered out to 10 years, you would restructure the ladder by buying a new 10-year bond with the first short-term bond to mature. As the bonds mature, the money in is reinvested at the longer end of the ladder, often at higher interest rates. Your income stream will stay relatively constant because only a small portion of your money will mature and be replaced each year. Over time, your holdings will include bonds purchased in periods of both high and low interest rates.

Here's how a bond ladder works during different stages in the interest rate cycle, says Strickland, who runs the Thornburg Municipal Income Fund:

When interest rates are unchanged, there is a steady annual return on the bonds. That return will be close to your highest-yielding bond.

During periods of rising interest rates, bond values initially drop. But with the bond ladder, maturing bonds will be annually reinvested at higher rates. Since maturing bonds are reinvested in higher-yielding bonds at the far end of the ladder, the yield on your overall holdings increases. The reinvestment serves to offset the price decline on your holdings when rates are rising.

On the downside, when rates are falling, the return of your holdings rises. The overall income stream will decline gradually because you are holding longer-term bonds. The income generated continues to be the average of all the bonds.

Strickland stresses that a bond ladder offers higher yields with less risk than trying to time the market or find the highest-yielding investment. Over the longer term, the yield on laddered bonds is similar to longer-term bonds. But the price stability is about in line with the five-year bond rate.

"In the face of interest rate changes and roller coaster market upswings and downturns, a bond ladder acts as a shock absorber to ease volatility and generate higher yields," Strickland says. "When you ladder a bond portfolio you avoid reinvestment risk."

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Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books).