How to Build a Bond Portfolio

(This article is part of a series on building bond portfolios. For more on this topic, see Wednesday's post "4 Important Considerations When Building a Bond Portfolio.")
When you build a bond portfolio, there are two types of interest risks you must consider:

Price risk, meaning the value of bonds rising or falling depending on interest rates
Reinvestment risk, meaning the chance interest rates will be lower when bonds expire and new ones must be purchased

Minimizing price risk comes at the cost of accepting reinvestment risk, and vice versa. A prudent solution to finding a balance between these risks is to create a laddered bond portfolio.

Laddering involves building a portfolio of individual bonds with increasingly longer maturities, such as equal amounts of bonds with maturities at regular intervals. Since buying small lots of individual bonds can increase costs, the number of bonds and the number of maturities used might be influenced by the dollars available -- the larger the portfolio, the more individual bonds and maturities can be used in constructing the ladder.

Advantages

You can match the maturities to your known or desired cash-flow needs (for example, paying for college).
You can better balance price and reinvestment risk.
You don't have to pay a fund manager.
Trading expenses are minimized, since you're not frequently trading to gain an edge.
For taxable accounts, you can harvest losses at the individual bond level.
Your income stream stays relatively constant, as only a small portion of the portfolio matures each year.
If interest rates rise, the price of bonds with longer maturities will fall. However, when the bond with the shortest maturity is paid off, the proceeds are used to once again extend the ladder to the desired length -- and you'll benefit from the higher current yields. On the other hand, if interest rates fall, while the proceeds of the maturing bond will have to be reinvested at lower rates, the other bonds will be earning rates above those currently available and the value of the portfolio will have increased.

Over time, a 10-year laddered portfolio (with about 10 percent in each maturity bucket) will have a maturity of five years on average, but the yield will be the 10-year trailing average of 10-year bonds. This is a significant, and often overlooked, benefit of laddered portfolios that cannot be achieved with other strategies.

More on MoneyWatch:
Why the Concern over Negative TIPS Yields Is Overblown Vanguard Bond Funds Are Not All Created Equal The Truth About Municipal Bond Costs What to Consider Before Investing in Municipal Bonds Why Bond Market Outperformance Is So Tough
Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.

Larry Swedroe

Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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