With interest rates at near-record low levels it appears that the only way for rates to go is up.
As the U.S. economy moderately strengthens, that means the bond bubble will begin to leak. Even darker, the bubble might just burst altogether.
The prospect of yet another bursting bubble makes investing in bonds difficult. The same is true for stocks.
After all, stocks tend to underperform when rates head north, while gold will certainly drop back once interest rates begin to rise ahead of inflation (which may take a considerable time.)
However, there is one strategy that enables you to prosper even in this tough environment.
It is called the bond ladder. It works like this…
Bond investing in a rising rate environment can be a terrific way to lose money.
If you buy short-term bonds, the yields may well be less than inflation, causing you to lose money in real terms.
And if you invest in long-term bonds, your immediate yield will generally be higher, but you run a large risk of losing part of your principal as rates rise and bond prices decline.
These losses can be a large multiple of your interest payments.
For example, if 30-year bond yields rise from their current 3.11% to 5.11% over the next year, your principal loss on a 30-year T-bond will be $30 on every $100, far more than the $3.11 you will have received in interest.
Of course, if you hold the bond for the next 29 years you will get your principal back at maturity.
But meanwhile you will have spent 30 years locked into an investment at interest rates below the market, and probably below the level of inflation. Not a wise choice.
Investing in Bonds: Building a Bond Ladder
The problem of investing in bonds then is one of reinvestment. You really don't know at what rate you will be able to reinvest your money when the time comes.
This problem is solved by buying bonds in a range of maturities, from short to long, and reinvesting the proceeds of each investment as it comes due.
For example, you could invest 10% of your money in each Treasury bond maturity from 1 to 10 years.
Then when the first bond came due in year 1, you would reinvest the proceeds in a 10-year bond, so you would again have 10 equal bond investments coming due in years 2 through 11.
Here's a concrete example.
Suppose you have $100,000 to invest today and you want to invest conservatively, protecting your principal against loss and your income against rising interest rates. You could invest in a 5-year bond ladder with $20,000 in each of 1, 2, 3, 4 and 5-year Treasuries.
Your bond yield would roughly be as follows:
- A 1-year Treasury yield of 0.16%;
- A 2-year Treasury yield of 0.26%;
- A 3-year Treasury yield of 0.40%;
- A 4-year Treasury yield of 0.62%;
- And a 5-year Treasury yield 0.86%.
Altogether, in the first year, your investment would yield 0.46%. Not wonderful, but it is better than many bank deposits.
At the end of the first year, if interest rates had remained flat, you would invest in a 5-year bond, maturing in year 6, again at 0.86%. However, in the second year you would earn 0.60% on your money – because you would have two 5-year yields at 0.86% (one of them a year old) and no 1-year yield.
Yet you would still have investments of 1, 2, 3, 4 and 5-year maturities since all of them bumped down one year.
Of course, if interest rates had risen to 2% for your 5-year bond reinvestment, your second-year yield would be 0.83% — your initial 0.16% 1-year bond would have been replaced with a 2% 5-year bond.
In the third year, if 5-year yields were still 2%, your yield would rise to 1.18%. That's the beauty of laddering.
After a time, even though you've kept your maturity short and your principal risk small, you're earning a medium-term (normally higher) yield on a shorter-term investment; in this case, a 5-year return on an investment with an average maturity of at most 3 years (and 2 years and 1 day just before a maturity).
If at annual renewal you think interest rates have risen as far as they are going to go, instead of reinvesting in a 5-year bond you could reinvest in a 10-year bond, locking in a higher yield for a longer period.
However that won't happen for a long time yet.
The long-term average yield on 10-year Treasuries is about 2.5% above inflation, so you should not reinvest in 10-year Treasuries until their yield is at that premium above the current inflation rate.
With the consumer price index up 2.7% in the last year, that would imply a 10-year Treasury yield of 5.2% — a long way above the current yield of 1.93%.
A New Wrinkle: Floating Rate Notes
There's an additional wrinkle. The U.S. Treasury has announced that sometime in 2012 it will begin issuing Floating Rate Notes (FRNs).
These will pay interest at a variable rate, which will be reset every few months, probably at a margin over the prevailing Treasury bill rates. Investors in FRNs will be protected against interest rate increases, because as Treasury-bill rates rise, the interest payable on FRNs will rise along with them.
That means the FRNs will always trade close to par – with one important caveat. If the credit quality of the U.S. Treasury deteriorates, then the FRNs may decline in value, because long-term U.S. Treasury paper will trade at a discount to short-term. You won't get par on a Greek FRN today, for example!
Nevertheless, depending on how they are priced there should be a decent premium of perhaps 0.5% over 3-month bill rates. But the Treasury may always get greedy and issue the first FRNs with a smaller premium.
Even still, FRNs look like they may be a good alternative for some of your money in a rising interest rate environment.
However, for most of your money you're probably better off with a 1-5 year bond ladder. The yield won't be exciting initially, but you'll be well protected if the bond bubble springs a leak.
If it does, the opportunity to get 5-year interest rates on an investment with an average maturity of 2-3 years will suddenly be very attractive.
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