It may not be an issue during the current environment of rising interest rates, but reinvestment risk never goes away. It’s most acute when you put all your eggs in one basket and buy that one bond with a great coupon rate.
Trouble arises when that bond matures, and interest rates have dropped. Then what do you do?
You can avoid this problem and mitigate reinvestment risk through a simple portfolio construction technique. It’s called a “laddered bond portfolio,” and investment professionals have used it successfully.
“Laddered portfolios hold short, medium, and longer bonds,” says Holmes Osborne of Osborne Global Investors in Odessa, Missouri. “Since interest rates are difficult to predict, a laddered portfolio can cover investors in multiple scenarios.”
You don’t need a professional to build this kind of portfolio. You can do it yourself. It’s not just a good defense to protect you against reinvestment risk. During a period of rising rates, you will find that a laddered bond portfolio can allow you to build cash flow.
“A laddered bond portfolio is one in which you invest in an assortment of bonds with staggered maturities,” says Robert R. Johnson, Professor at the Heider College of Business at Creighton University in Charlottesville, Virginia. “For example, you can structure a bond portfolio where 10 percent of all the bonds mature each year. The bonds would not all mature in the same interest rate environment. If rates rise, the value of the portfolio may fall, but you do not need to sell the bonds that haven’t matured. If you need the cash, the maturing bonds offer a ready source. If you do not need the cash, you can reinvest the proceeds of the maturing bonds at the new (higher) interest rates.”
While the Fed has increased interest rates to stave off inflation, normal interest rate increases occur during the upside of a booming economy (which is also associated with rising inflation). When the economy slows or slows too quickly, you would expect the Fed to cut interest rates to help spur economic growth.
It’s during this part of the cycle that reinvestment risk arises. A laddered bond portfolio mitigates reinvestment risk.
“Reinvestment risk occurs when you have to invest the proceeds from a bond at a lower rate than what the original bond paid,” says Tommy Gallagher, an ex-investment banker and the Founder of Top Mobile Banks who lives in Berne, Switzerland and Ann Arbor, Michigan. “This can be a problem when interest rates are falling, as you cannot reinvest the proceeds at the same rate as when you initially purchased the bond. By laddering the bonds, you can still maintain some of your original investment if rates fall.”
Going back to his example, Johnson says, “If interest rates fall, you will reinvest the proceeds at a lower rate, but only for 10 percent of the portfolio (and the longer maturity bonds would rise in value). With a laddered portfolio, the proceeds of the maturing bonds would be reinvested in new bonds with a maturity later than those currently in the portfolio.”
If you’re not familiar with investing in bonds but more familiar with stock investments, you might recognize the following analogy.
“A bond ladder reduces interest rate risk by staggering the maturities among several bonds (each of which represents a rung on the ladder),” says Johnson. “For a long-term investor, that ends up being similar to a dollar-cost averaging strategy in the equity markets. Shorter maturities cushion interest rate (i.e., bond price) risks, while the fact that only a portion of the bonds mature in a given period reduces reinvestment risk.”
One reason you might want to invest in an extensive bond portfolio is to generate reliable cash flow. This strategy of buying a set of bonds with a mix of maturity dates can help you here, too.
“In addition to mitigating reinvestment risk, laddered bond portfolios can also provide a steady stream of income,” says Gallagher. “By investing in bonds of different maturities, you can take advantage of higher yields as they become available and benefit from any increases in interest rates. This can be especially beneficial for those investors looking for a steady stream of income over time, as the laddered portfolio will provide a steady cash flow of income and capital gains as each bond matures.”
Generally, retirees will employ a laddered bond portfolio strategy. It’s best when you have a critical mass of assets to realize the complete set of benefits found in this style of investing.
“Overall, laddered bond portfolios can provide you with a way to mitigate reinvestment risk and generate a steady stream of income over time,” says Gallagher. “By laddering the bonds, you can take advantage of different yield curves and benefit from any increases in interest rates. In addition, this strategy can provide you with a steady stream of income without having to worry about reinvesting your proceeds at a lower rate than what you purchased the bond at.”
Are laddered bond portfolios right for you? You need to consider your investment objective. If you continue to need solid long-term growth, this strategy might not be appropriate. If, on the other hand, you have an income-oriented objective, you might want to take a look at this.