Thursday, April 25, 2019

Hedge Your Bets

Ask the CFP

“Courage is the ladder on which all the other virtues mount.”

 ~ Clare Boothe Luce, U.S. Congressman, Ambassador and Author (1903-1987)


Question:  What is a “bond ladder”?

Answer:  A bond ladder is a portfolio of bonds with maturity dates spread over months and years in regular intervals. In other words, it’s a technique used by bond investors to hedge their bets. Whenever a bond matures, the proceeds are reinvested back into the long end of the ladder, thereby maintaining the integrity of the portfolio’s general structure.

According to the Etymology Dictionary, the phrase “hedge your bets” dates back to the late 1600s. The word hedge was used then as it is now, referring to shrubbery used in landscaping as a fence to provide protection. Being a less rigid structure than a wall, a hedge remains more flexible, allowing for pivots and changes along the way. As a noun, hedge refers to any fence; and as a verb means to surround with a barricade or palisade for the purpose of evading, dodging or avoiding commitment. In 1672, George Villers, the Second Duke of Buckingham, used the term in his play “The Rehearsal” as follows: “Criticks, do your worst, that here are met; For like a Rook, I have hedg’d in my Bet.”  

Before going any further, let’s recap the difference between stocks and bonds. Shares of stock represent ownership of a corporation and are often referred to as equites. Corporations offer or sell shares (equity) to raise capital for expansion and growth of a business, funding new projects or to pay down debt. In contrast, bonds represent a debt owed by the issuer to the bond holder. The premise is that the loan will be repaid at an agreed upon date with interest in return for use of the funds. Bonds are also referred to as fixed income instruments. Bond variables include interest rate and maturity date.

Why Use a Bond Ladder?

Using a bond ladder may lessen the impact of reinvestment risk by spreading the maturity range over time increments, usually months and years. It’s the same method used when constructing a portfolio to avoid having too high of a concentration in any one issuer or industry. In most instances, a bond portfolio shouldn’t be overly concentrated in any maturity. Picking a small window of maturities or grouping of bonds with a similar trait, such as being all short maturity bonds, may create and place an emphasis on reinvestment risk because of a concentration of “like” bonds. A laddered structure allows for diversification of maturities, sectors, coupons, or any other bond attribute.

When considering how to position fixed income or bond allocations, it’s important to consider both current value as well as long-term planning. This is why a popular strategy for some investors has been and may remain, the individual bond ladder.

What if Rates Rise?  

A bond ladder takes advantage of a rising interest rate environment, while being fully invested and earning income all along the way. As interest rates rise, maturing principal is reinvested back into the bond ladder at the new higher interest rates, leading to a gradual increase in the overall yield of the portfolio over time.

A bond ladder prevents the potential pitfalls of “betting” on a single future scenario (i.e. investing all money in short maturity bonds). Betting like this, may “win” if rates quickly rise by allowing reinvestment in future higher rates, but “lose” if rates remain flat or fall by sacrificing current higher income associated with longer maturities. This exposes the reinvestment risk mentioned above by not having the “rolling liquidity” that a bond ladder provides. In the stock portion of a properly constructed portfolio, it’s not typically recommended to place everything in one company. This would concentrate the entire outcome on one entity, not a likely tactic for most investors. Concentrating an entire fixed income portfolio in a single maturity might be an equally alarming practice.

Regular Liquidity

The various maturities in a bond ladder can provide an excellent liquidity source for unexpected expenses or opportunities. For example, a ladder “roll off” could keep an investor from having to sell or liquidate a bond in when the markets are unfavorable resulting in realizing a loss or abandoning desirable income. Continuous maturities also provide the opportunity to reposition the portfolio into different asset classes, sectors, credit quality, maturity range, etc. if appropriate in response to external forces such as one’s investment objectives and/or market dynamics.

Using a properly designed bond ladder may alleviate concentrations in specific bond traits and may mitigate some risk. Although considered a more conservative approach, a laddered portfolio can be used as part of an overall well-crafted and implemented financial plan to position an investor with more moderate reinvestment risk and improved returns.  Stay focused and plan accordingly.

Keep in mind that there is no assurance that any strategy will ultimately be successful or profitable nor protect against a loss. There are special risks associated with investing with bonds such as interest rate risk, market risk, call risk, prepayment risk, credit risk, reinvestment risk, and unique tax consequences. To learn more about these risks and the suitability of these bonds for you, please contact our office. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. There is an inverse relationship between interest rate movements and fixed income prices. This does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.

The opinions expressed are those of the writer, but not necessarily those of Raymond James and Associates, and subject to change at any time. “Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.”  

This article provided by Darcie Guerin, CFP®, Vice President, Investments & Branch Manager of Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC, 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. She may be reached at 239-389-1041, email darcie.guerin@raymondjames.com; Website: www.raymondjames.com/Darcie.

 

 

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