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
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.
- 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.
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