How do you hit a moving target?In the case of interestrates, you shouldn't even try.Instead, build yourself a ladderedbond portfolio. Being prepared ismore important than having good aim.
Shoots and Ladders
A laddered bond strategy providesexposure to higher yields while minimizingrisk of capital losses. It also providesfor some liquidity, because a ladderedbond portfolio is structured so that a portionof it comes due on a regular basis.
A recent article suggests ladderingbond investments over a 10-year period.To do so, divide the amount you wishto invest into 10 equal portions, and thenpurchase bonds that mature in each ofthose 10 years. When a bond matures,replace it with a new 10-year bond.
What you are doing is continuouslyinvesting a portion of your capital in thecurrent bond market. If rates rise, you willhave money each year from a maturingbond to reinvest in higher-yielding andcheaper bonds. If interest rates decline,you will have funds available to purchasemore expensive, lower-rate issues.
Of course, a laddered bond strategydoes have drawbacks. For example, if youladder bond investments over a 10-yearperiod, you are only reinvesting 10% ofyour portfolio each year. Thus, if interestrates rise, 90% of the portfolio willremain tied up in securities with lowerrates. Despite this, many advisors considerbond laddering a better approach in aninflationary environment.
What type of bonds should your ladderedstrategy be built upon? Investmentmanagers suggest avoiding corporatebonds because they may not be tax efficient. You could end up paying tax onthe income and not taking full advantageof capital gains taxes.
One option is US Treasury bonds,which offer tax benefits and are easy tobuy and sell (www.publicdebt.treas.gov).Municipal bonds are another good choicebecause they are exempt from federaltaxes—they could be exempt from stateand local taxes too.
You might want to also consider prerefundedor escrowed-to-maturity bonds.Money to repay the bonds is placed in atrust at issuance, providing a level ofsafety similar to that provided byTreasuries, but with a higher return. Ifinflation is a concern, look into Treasuryinflation-protected securities. Payout islinked to the rate of inflation.
Of course, returns on a laddered bondportfolio will be small compared withhigh-risk investments. But it's a simple,conservative strategy that requires limitedeffort. Sound appealing? If so, get in touchwith your advisor.