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How Bond Laddering Can Reduce Portfolio Risk

The greatest defense you have against a market crash is broad diversification. The more diversified your portfolio is, the more insulated it is for crashes that only take down portions of the market, and the less likely your entire portfolio will suffer the same fate as the broad market.bond-laddering

There are numerous diversification techniques, but one of the most useful when it comes to bonds is the “laddering strategy.”

Bond laddering is when an investor buys bonds with significantly different maturity dates. The dates are evenly spaced across several months (or years), so that at regular intervals, the bonds mature and principal is repaid. The investor can then reinvest the proceeds, either for the same maturity length, or a different one depending on how economic conditions have changed. The investor may even choose not to reinvest the money, but rather use it for some other purpose.

How does this reduce risk?

First, recall that bonds are debt issued by companies, governments and municipalities. Those bonds will have many different maturities, ranging from months to decades. The further out a maturity date is, the more risk is attached to that bond, and consequently the higher the interest rate will be. The reason for this is that the longer a maturity a bond has, the more things that could go wrong for the debtor.

There are several risks which are somewhat mitigated by laddering, including:

Interest Rate Risk

Suppose you buy a bond with a certain maturity date that pays a certain interest rate that you are happy to get. Then, things change. Interest rates rise. You are still stuck with that other bond paying less. Not only that, investors holding your same bond will sell it in order to buy the higher-yielding bond, and that will cause the value of your bond to decline.

By staggering maturities, if rates rise you’ll be able to have some of your capital returned to you on a regular basis, allowing you to reinvest at the higher rate.

Inflation Risk

Suppose you buy a bond paying 3%, which you’ve chosen because that’s the rate of inflation. You want your investment to retain its purchasing power, after all. Well, if inflation rises to 4%, now what? If you’ve committed all your capital to the 3% bond, you are now not earning a rate equal to inflation.

Default Risk

Remember, a bond is essentially a loan that you are financing. The entity uses the money to finance its business, or in the case of a government, to finance specific projects. Bonds are issued on the assumption that the borrower is actually going to repay the loan, and will pay interest along the way to compensate you for the time use of your money – as well as to reflect the risk of default.

So what happens in a default? You lose the principal. While this in generally unlikely to occur, it can and does. Detroit is a great example.

With bond laddering, you are diversifying across so many different types and maturities of bonds that should a default occur, it will have minimal impact on the overall portfolio.

Liquidity Risk

Liquidity risk generally applies to corporate bonds. The idea here is that if the company that has issued the bonds is struggling, or if it is an obscure company, there may not be enough buyers should you decide to sell your bond. You could get stuck with it, incurring all the other risks already discussed. Again, bond laddering will reduce any such impact on your portfolio.

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