SmartInvesting.ca

List of Articles

Laddering Your Bond Holdings Yields Important Diversification Benefits

by Wayne Cheveldayoff, 2003-05-11

Like equity investments, bond holdings in a portfolio need to be well diversified as a way of minimizing risk and lost opportunities. A successful strategy for doing this is the bond ladder, which spreads risk over a series of different maturities.

In fact, for most investors, the risk in bonds (excluding corporate bonds, as noted below) lies mainly with the maturities of the bonds they hold. It is the nature of bonds that prices and yields have an inverse relationship. The prices of outstanding bonds traded in the marketplace fall as interest rates rise, and bond prices rise as interest rates fall. It is also a fact that a change of interest rates will affect the price of long-term bonds more than the price of short-term bonds.

If the bonds in a portfolio are all short-term bonds with a maturity of, say, three years or less, the investor will lose out on the large capital gains that occur for long-term bonds when interest rates fall (as they have for several years). At the same time, a bond portfolio made up of long-term bonds will suffer significant capital losses if interest rates rise sharply.

To deal with these risks, bond fund managers use a laddering approach to their portfolios, and individual do-it-yourself investors would be wise to follow this lead.

Here is how the bond ladder works. You split the bond portion of the portfolio equally into bonds due to mature, say, in one year, three years, five years, seven years and nine years. This works out to an average maturity of five years, which is roughly the same as most bond index funds. But a ladder with a five-year average is not the same as holding a five-year bond, where the principal is returned only after five years.

With a ladder constructed in this way, when the one-year bond matures (in one year’s time), you have one-fifth of the original principal for reinvestment. You invest this in 10-year bonds, thereby maintaining an approximate five-year average. Two years after that, when the three-year bond matures, you re-invest again in 10-year bonds. And so on.

The strategy essentially relieves investors from having to make predictions on interest rates. If interest rates go up, you know that you will have money coming available to take advantage of the higher rates.

A bond ladder can be constructed with any type of bonds, but government bonds are usually used since they are widely available in the maturities required and have virtually no default risk (at least in Canada). Government strip bonds are also frequently used. (Strip bonds, where the coupons and principal are stripped and sold separately, have greater leverage and are more volatile in price than ordinary bonds that pay interest regularly.)

With corporate bonds, there can be significant default risk that complicates the strategy. Unless your portfolio is big enough so that you can diversify your holdings among 10 to 20 issuers, the best strategy with respect to corporate bonds is to invest in a corporate bond fund where the manager can achieve proper issuer diversification.

The bond offerings of most investment dealers are varied enough for investors to custom build the ladders they want. Indeed, some dealers actually make is easy for their customers by packaging bonds together into ladders that are held in inventory and can be, in effect, purchased off the shelf, although maintaining the ladder in the future as bonds mature is the responsibility of the investor.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at wcheveldayoff@yahoo.ca.

The URL for this page is http://www.smartinvesting.ca/articles/20030511020100.html .


©2003 Wayne Cheveldayoff