South Florida investors buy bonds for many reasons. One of the most important is the degree of stability they can bring to a portfolio when used as a complement to assets like stocks.
Stocks or equities are generally considered to be growth assets, as historically they have outperformed bonds, money market funds, certificates of deposit and other types of assets. Stocks can also help investors overcome the risk of inflation, which can reduce the buying power of the dollar.
However, owning bonds directly can reduce the overall volatility of your portfolio. While stocks can move up or down in value quite rapidly due to changes in market conditions or investor sentiments, bond values tend to fluctuate within a much narrower range.
Another reason for holding bonds is their ability to provide a steady flow of income, which is why they are referred to as fixed income. That aspect is particularly appealing to seniors who rely on bond interest income payments, as well as their Social Security checks, to pay the monthly bills and enjoy a comfortable lifestyle in retirement.
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One strategy for managing those cash flows is building a “bond ladder.” This approach, which is best suited for investors who already have an investment portfolio, involves holding bonds with sequential maturity dates in order to maintain a relatively smooth flow of income and address some of the potential reinvestment and interest rate risks.
Let’s say you hold five $10,000 investment-grade corporate bonds with 10-year maturities now paying 3 percent. Now, a lot can happen in the financial markets before 2027, while you hold those fixed-income assets.
Interest rates could rise, but you would still be locked into that low level of income. Also, bond prices fall when interest rates rise, and the longer a bond’s maturity, the more sensitive it is to this risk. If you hold a bond to maturity, these price fluctuations have little to no relevance.
Bonds are also subject to other risks that can increase with time. For instance, the issuer might be unable to make interest and or principal payments on a timely basis, an issue called credit risk. That could reduce the market value of your bonds.
Another issue is call risk, the possibility that an issuer might decide to redeem your bond before the scheduled maturity date. If rates are lower at that point in time, you may not be able to obtain the same level of income from your bonds, an issue called reinvestment risk.
With a bond ladder, you and your financial advisor can develop a plan to hold securities with different maturity dates to reduce your exposure to those risks. Instead of holding five 10-year bonds, in this hypothetical example, you might decide to purchase five bonds maturing in one, three, five, seven and 10 years.
Now, if interest rates jump in 2018, you could roll over the bond with a one-year maturity and purchase a new bond at a higher rate. Or if rates decline, you could buy another bond with only a modest reduction in your portfolio value.
In general, a bond ladder strategy provides you with a higher degree of flexibility versus a longer target maturity. Every time one of those $10,000 bonds comes due, you can make a decision at that point as to how to use those proceeds. You could reinvest the money in a new bond, purchase a different type of asset or use that cash for other purposes, such as an unexpected medical or home repair expense.
When building a bond ladder, you should also consider tax efficiency and diversifying the types of fixed-income securities in your portfolio. Rather than owning $50,000 in corporate bonds, you could purchase government bonds, municipal bonds or Treasuries. Diversifying types of bond holdings as well as the maturity dates can help reduce potential volatility and stabilize the value of your portfolio.
Whether you are an experienced investor or just starting to save for the future, it’s important to understand the value bonds can play in your portfolio. Talk with your financial advisor about your goals and risk tolerance to develop a strategy that makes sense for you.
Andrew Menachem, CIMA®, is a wealth adviser at The Menachem Group at Morgan Stanley in Aventura. Views expressed are those of the author, not necessarily Morgan Stanley, and are not a solicitation to buy or sell any security. The strategies and/or investments referenced may not be suitable for all investors. Follow Menachem on Twitter @AMenachemMS.