Be Ready for a Change in Interest Rates

When it comes to interest rates, about the only thing you can count on is change. The Federal Reserve, which uses interest rates to influence economic activity, has adjusted the federal funds rate — a key benchmark for other interest rates — more than 240 times over the past 40 years.¹

Fluctuating interest rates can be challenging for bond investors. When bonds mature during a period of low rates, bond investors may have to accept lower yields when they reinvest their money. On the other hand, if rates rise at a time when their principal is tied up at lower interest rates, they may not be able to take advantage of higher yields.

Fortunately, there is a strategy to help manage the risks associated with fluctuating interest rates.

Climbing the Ladder

One upside of bond investing is that the interest rate on an individual bond is generally fixed throughout the life of the bond, providing the bondholder with a fairly predictable income (unless the bond issuer defaults). When the bond matures, however, the amount of future income the bondholder can expect from reinvesting the principal is highly dependent on the current interest-rate environment.

One way to help manage reinvestment risk is by staggering the maturity dates within a bond portfolio so that at least one bond matures every year or two. This strategy, known as a bond ladder, may help limit exposure to falling interest rates while also increasing the likelihood that at least some principal may be available to reinvest when rates are rising.

A bond ladder is a form of diversification because it helps spread risk over a period of time. Of course, diversification does not guarantee against loss; it is a method used to help manage investment risk.

The principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investments seeking to achieve higher yields also involve a higher degree of risk.

Building a bond ladder has no effect on the underlying risk of the bonds themselves. However, ensuring that only a limited portion of a bond portfolio matures at any given time may be an effective way to help manage reinvestment risk.

1) Federal Reserve Bank of New York, 2010

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2011 Emerald Connect, Inc.