Stay on the Ladder
Published On: October 19, 2021
Written by: Ben Atwater and Matt Malick
With inflation heating up and bond yields still paltry, some are again questioning the use of fixed income (bonds) in portfolios.
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 2022, 2023, 2024, 2025, etc.
The idea behind this is twofold. First, since interest rate movements are impossible to predict, having a maturity each year allows us to reinvest in a new interest rate environment in a disciplined fashion.
Not only can we reinvest maturities, but we 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, again in a disciplined fashion.
We cannot overemphasize this aspect of our fixed income process. Having a set maturity date creates a decision point at a specific time. Contrast this with cash, which is a nebulous holding. The idea that one is going to deploy cash at “the right time” is most often wishful thinking, which requires a high degree of pure luck.
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 the 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 spike in inflation and rising interest rates, and this has been damaging to bond prices. If rates continue to rise, stocks will likely remain volatile. 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 is impossible to predict the path of interest rates. We have been hearing our entire careers that rates are going to rise, and they are only now starting to do so, and even this time could be a bigtime head fake. Indeed, countless scenarios could derail the path to higher rates. If rates do rise materially, we have a sound strategy that, with patience and discipline, will ultimately take advantage of market dislocations that higher rates create.
Just as we would never wish for an event that forces us to call the insurance company, we also do not 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.