Somewhat lost in the headlines last week was the biggest three-day move in bond yields since 1987. That lack of attention is not entirely unexpected given that we also experienced the second and third-largest bank failures in U.S. history. But each of those stories has a valuable lesson to convey around bond risk.
So, let’s take a look at some of the risks that bond investors face and how one can mitigate those risks by spreading out maturities, in this case, via a bond ladder.
As an example, the much-discussed failure of Silicon Valley Bank was largely the result of a run on liquidity and a duration mismatch. In essence, SVB invested money they ended up needing in the short term into long-term securities. When rates rose, those long-term securities declined in market value, which meant the bank had to sell high-quality assets at a loss to shore up their liquidity.
Even absent the bank run, SVB was poised to take a billion-dollar loss on the assets they were selling. The bank run simply exacerbated the problem.
SVB weighed the risk of not making enough money on their deposits against the risk of becoming illiquid and made the wrong choice. That’s a choice that fixed-income investors face every day, and it can be mitigated via staggering maturities through a bond ladder.
You can build a bond ladder by buying a series of bonds or bond funds with staggered maturity dates. Then, as each security matures, you reinvest the proceeds in a new security at the top of ladder, which becomes your new longest-dated security.
If interest rates are rising, the new investments will have higher coupon rates than the investments rolling off the bottom of the ladder, and your yield will gradually rise. This is particularly valuable in uncertain markets as it allows you to avoid locking assets entirely in either low-yielding, short-term bonds or higher-yielding bonds that will decline in value as rates continue rising (as with Silicon Valley Bank).
For example, if you wanted to create a bond ladder today, you could buy bonds maturing in 2023, 2024 and 2025. When your 2023 bond matures, you would invest the proceeds in a 2026 bond, which will most likely be offering a higher interest rate than currently available bonds.
While longer-term bonds yield more, shorter-duration fixed-income investments carry less interest rate risk. In other words, if you expect rates to continue heading higher, you’ll want your longest-dated bond to still mature fairly soon (probably within five years) so you’re not stuck holding a bunch of very low-yield fixed-income investments for a long time.
If your liquidity needs are not a concern and interest rates are holding steady, you can lengthen your ladder by incrementally buying later maturities (in the example above, using half of your proceeds to buy 2026 bonds and half to buy 2027 bonds). This requires a little more active management but does help ensure that you’ve locked in more money while rates are high.
In an interview we did with value investor and former longtime Cabot analyst J. Royden Ward, he described a bond ladder as such:
The most important part of creating a bond ladder that will preserve your capital and work in a rising rate environment is that you only buy individual bonds or defined maturity bond funds.
Unlike standard bond funds, bond funds with maturity dates preserve the principal guarantee you get with individual bonds, or the promise that you’ll get your original investment back when the security matures. For most investors, BulletShares ETFs are the simplest way to construct a bond ladder.
The ETFs come in both investment-grade and high-yield versions, with maturity dates from 2023 to 2032.
The BulletShares ETFs mature on either December 15 or the last trading day of the year in the name of the fund, at which time the NAV of the fund is distributed to shareholders.
Whichever funds you choose, when the first maturity in your ladder arrives, you can keep your bond ladder intact by reinvesting the redemption value into a new security at the top of the ladder. This will maintain your income stream—and if rates are rising, it will grow over time.
In the event you run into unexpected liquidity needs, the annual maturation of one-fifth (in a five-year ladder) of your bond holdings can help.
And, should rates begin to fall, your portfolio holdings will grow in value because they’re paying above-market rates.
Do you consider bonds a cornerstone of your portfolio in today’s interest rate environment?
*This post has been updated from a previously published version.