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BondsOnline
Advisor
February,
2002 How
to "Ladder" Your Portfolio
By Stephen Taub
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Will the Fed cut rates again? Will they tighten later in the year? Will bonds outperform
stocks for a third straight year?
None of this matters if you're invested in fixed-income securities as part of an overall
asset allocation strategy. Rather, you should be structuring a time-worn strategy called
laddering, which if carved correctly should be mostly devoid of short-term market concerns.
"The allocation formula doesn't change whether you are bullish or bearish," says
Michael Ryan, managing director and senior fixed income strategist at UBS PaineWebber Inc.
Rather, your laddering strategy is more dependant upon where you are in your investment life cycle.
"Laddering is about future liabilities and funding needs," he adds.
Laddering, as you may be aware, is a popular diversification strategy whereby you
purchase bonds of different maturities in order to cut your interest rate risk. So, for example,
if you buy equal amounts of securities with maturities of two, four, six, eight
and ten years, when the two-year note matures you might reinvest it in a 10-year note in
order to capture a higher overall yield than if you just invested in two-year paper. And
this exercise is repeated every two years as another security matures. The thinking is that if rates fall,
you'd have to reinvest this money at a lower rate. But, the other
issues would be throwing off a higher return. If rates rise, your portfolio
would wind up sporting a lower-than-market rate, but you'd
have a chance to adjust it in two years.
So, what's the best way to deploy this laddering strategy? Well, it all depends upon your
age, current and future cash flow needs and stage of life. "Too often individual investors
get caught up with what looks cheap on the yield curve," says Ryan.
Rather, laddering is largely about future liabilities and funding needs. What do you need
money for? Health care? Steady retirement income stream? College tuition? Some other
event? So, you must decide whether you need money in, say, 10, 15 or 20 years or just
one or two years. "There's no cookie cutter" strategy," Ryan points out.
That said, if you are in your 20s, for example, you should generally devote less of your
overall portfolio to fixed-income. Then, the slice that is invested in fixed-income should
be concentrated in the riskier, higher-yielding segments. "Securities with higher volatility
and higher potential returns and less immediate cash flow," says Ryan.
Also, you shouldn't worry about part of the portfolio maturing for many years. For example, Ryan says
young investors should devote most of their fixed-income
allocation to high yield and zero coupon bonds. Zero coupon
bonds with 15- to 20-year maturities are especially attractive for young people who want to
conservatively save for their children's college
education.
If you are 50 or so, you still may not need the cash flow for a number of years. So, you should be thinking
about having your first bonds come due in eight to ten years. "You can (still) earn a higher rate of return,"
he points out.
These investors should gravitate to higher risk paper, such as corporate bonds, and perhaps high yield bonds.
"Maybe mortgage-backed securities," Ryan adds. "You should
not be heavily weighted toward the Treasury market," he adds.
Once you're approaching retirement--say 60-years old--your earning potential is obviously
limited. Your ability to sustain and recoup losses is less.
"Your horizon is shorter versus someone who is 40," Ryan adds.
So, this is the time to move toward shorter maturities.
Take less risk. He recommends agency paper, higher quality corporates such as AA-rated paper, and Treasurys.
"You may need more reliance on cash flow," he notes.
So, instead of buying paper that is maturing every two years,
for example, you would want to look at securities
maturing every year or even six months. "You can also structure
a coupon maturing quarterly, or in some cases monthly," he adds.
At the longer end of the maturity scale, this person would probably not want any maturities to exceed 15 years.
Ryan reminds investors: "You should focus less on capturing the final, extra basis point."
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