Diversifying your portfolio, generatingincome, and possibly addingsome stability to your holdings arejust a few of the many reasons to invest inbonds. But choosing the best bond investmentstrategy can sometimes be a bittricky. Whether you are a seasoned fixed-incomeinvestor or have never bought abond, a laddering strategy can help reducevolatility and avoid concentrating reinvestmentrisk in your portfolio.
First Financial Rung
First, let's look at how bonds work.When you purchase a bond, you essentiallymake a loan to the government ora company, called the issuer. In return,the issuer pays you interest on yourmoney. Then, when the bond reachesmaturity, the issuer repays you the facevalue, or principal amount of the bond.Now that you have the essentials, let'slook at a strategy you can possibly applyto your own portfolio.
To begin a bond laddering strategy,you purchase equal dollar amounts ofbonds with different maturities. Forexample, let's assume you have $50,000to invest. You can create a laddered portfolioby investing $10,000 each in bondsthat would mature in 2006, 2008, 2010,2012, and 2014.
When the first bond reaches maturityin 2006, you would take the principalthat you receive, which is typically theface or maturity value of the bond($10,000) and reinvest it in bonds thatmature in 2016. You would continue thissystem of reinvestment each time yourbonds come due.
A strategy that concentrates in a narrowmaturity range might force aninvestor to reinvest into a very lowinterest rate environment. In contrast, aladdering strategy lets you reinvestgradually, maintaining a portfolio ofbonds earning different interest rates.Let's say the first bond you invested inhas reached maturity and it is time toreinvest the principal. If market interestrates are currently higher than thecoupon on the maturing bond, you willprobably be able to reinvest the principalat a higher rate of interest.Conversely, if interest rates are lower,you most likely still have a significantportion of your bond portfolio—thosethat have not yet matured—invested athigher coupon rates.
The interest or coupon rates associatedwith bonds are important becauseone of the main reasons many peopleinvest in them is to generate income.Most bonds pay interest semiannually, soin the example above, you could selectbonds that made payments in differentmonths of the year. This would provideyou with steady income throughout theyear that could cover living expenses.
Bonds can be a good choice for providingdiversity and adding income toyour portfolio. If you are looking for asimple and systematic approach toinvesting in them, you might want tothink about using a laddering strategy.Talk to your financial consultant aboutrisks associated with investing in bondsand see if they might be a good additionto your investment mix.
Joseph F. Lagowski is vice president, investments, and a financial
consultant with AG Edwards in Hillsborough, NJ. He welcomes questions or comments at 800- 288-0901
or www.agedwards.com/fc/joseph.lagowski. This article was provided by AG Edwards & Sons, Inc, member SIPC.