Jacob’s Ladder is an American horror movie starring Tim Robbins who plays a postal working trying to work his way back into society after a tour of duty in Vietnam and the death of his son. Jacob was dealing with both perception and reality.
Another horror story for investors is the thought of rising interest rates. When interest rates rise the price of a bond will drop. The price of a bond has an inverse relationship to interest rates. The relationship is like a see-saw in a park when one side goes up the other side goes down. The price of a 30 year bond today would fall 17.6% with a 1% rise in interest rates. To add to this horror story the 30 year U.S. Treasury bond is currently yielding about 2.85% so the thought of getting single digit interest while losing over 17% of your principal is not too compelling.
How can you avoid this horror show? A bond ladder. A bond ladder will help protect you against rising and falling interest rates. A bond ladder can be constructed with any type of bond or fixed income vehicle. You can create a bond ladder with CD’s, corporate bonds, tax-free municipal bonds or U.S. Treasury investments. You band ladder can have multiple rungs with multiple investments. The ladder can be manufactured with a short term or long term view. The choice is all yours.
What constitutes a bond ladder? A ladder is assembled by buying bonds that come due at different times. For example, a five year bond ladder can have investments maturing at one year intervals – 1 year, 2 year, 3 year, 4 year and 5 year. When the 1 year bond matures you will re-invest the proceeds into a new 5 year bond. The other bonds have now moved up by one year so your 2 year bond is now a 1 year bond and so on. By employing this strategy you will always have money coming due for you to take advantage of the current interest rate environment. This strategy can continue indefinitely.
What if interest rates fall? In this case your longer term bonds will get more expensive and trade at a premium because when rates fall your principal will rise. A 1% drop in rates will make our 30 year bond appreciate by 22.8%! This is the advantage of a ladder. You will have the ability take advantage of any type of interest rate move.
The bond ladder can be customized to your unique situation. A short term bond ladder can be nothing more than rolling 3 month CD’s for a year. This ladder would have CD’s maturing every 3, 6, 9 and 12 months. You can also take a long term view and buy nothing but 30 year bonds.
Bond ladders are not scary and can help you avoid your own horror show.
Bill Parrott is the President and CEO of Parrott Wealth Management, LLC. www.parrottwealth.com