Stay on the Ladder
Published On: October 10, 2018
Written by: Ben Atwater and Matt Malick
In life, we have precautions in place that we don’t want to use. Insurance comes to mind as a prime example. You don’t want to smash your vehicle to collect on your car insurance or burn down your house to collect on your homeowner’s policy.
Although far less dramatic, we designed our fixed income (bond) investment strategy to be a hedge against uncertainty.
For accounts where it is appropriate, we “ladder” bond maturities. This means that we generally structure the bond allocation of an account to have maturities occurring each year, for example in 2019, 2020, 2021, 2022, etc.
The idea behind this is twofold. First, since interest rate movements are impossible to predict, having a maturity each year allows you to reinvest in a new interest rate environment in a disciplined fashion. Not only can you reinvest maturities, but you also leave open the possibility of using the proceeds to fund cash flow needs or dollar-cost-average into equity positions if the stock market is depressed.
Second, by holding individual bonds to maturity, the price fluctuations that occur (bond prices fall when interest rates rise, and vice versa) are only paper fluctuations. When a bond matures, you will receive its par value, regardless of the fluctuating statement values between now and that maturity date. For example, in a rising rate environment, a bond might show a 5% loss based on current market conditions, but by holding this bond to maturity, all else being equal, the bond price will slowly return to par as the maturity date approaches.
Right now, we are experiencing a meaningful rise in interest rates and this has been damaging to bond prices. If rates continue to rise, stocks will likely also continue to suffer. But, having a laddered bond portfolio from which to make disciplined reinvestment decisions will prove a tremendous luxury in such a challenging environment.
As we said earlier, it’s really impossible to predict the path of interest rates. We have been hearing for eight years that rates are going to rise and they are only now starting to do so. And, even now, countless scenarios could derail the path to higher rates. If rates do rise materially, we have a sound strategy that, with patience and discipline, we can ultimately take advantage of market dislocations that higher rates will create.
Just as we’d never wish for an event that forces us to call the insurance company, we don’t hope for a period of time with negative stock and bond returns. In such a circumstance though, laddered bonds will prove strategic for patient and disciplined investors.
Please visit www.atwatermalick.com/ria for full disclosure materials related to recommendations contained in this update.