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TAKE A SENSIBLE STEP WITH A LADDERED PORTFOLIO
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Does this story sound familiar to you? An investor visited a local bank because his one-year certificate of deposit (CD) had reached maturity. He stepped up to the teller and announced he would like to roll his investment over into a new, one-year CD at the same rate. The teller, amused, tells the investor he is out of luck and then points to a display that lists the bank’s current CD rates -- two percentage points lower is now the best the bank can offer.
Investors are often disappointed to find out that the current interest rates are much lower than those of their previous fixed income investments. Fortunately, however, a proven investment technique is readily available to help make the most of an evolving interest rate environment.
Adopting a "laddered" portfolio approach allows an investor to minimize the interest rate risk that is associated with large, short-term fixed income investments. In a nutshell, this strategy adopts a longer-range outlook and diversifies the maturity structure of fixed income instruments within a portfolio. This enables the total return of fixed income investments to be less adversely affected by interest rate fluctuations.
Structuring a laddered portfolio with investments in successive maturities also allows an investor to achieve more flexible management of fixed income oriented assets. The laddered strategy can help accomplish the following goals:
* Achieve a higher total rate of return by extending the maturities of fixed income investments.
* Maintain liquidity within the portfolio through short-term holdings.
* Minimize interest rate reinvestment risk in lower interest rate environments, since the higher rates are "locked in" to the longer maturities.
* Provide the flexibility to reassign short-term holdings to long-term investments during periods of higher interest rates, in order to lock in those higher rates.
Here are three ways that laddered fixed income portfolios can help an investor succeed in different interest rate environments:
* Interest rates remain constant. The yield of the portfolio will increase each year because investment in longer maturities will "average up" the total return.
* Interest rates drop. The portfolio is protected against reinvestment risk, because longer-term maturities continue to earn higher rates.
* Interest rates rise. As shorter maturities come due, proceeds are reinvested at new, higher levels, thereby improving portfolio return.
The large variety of fixed income investments currently available enable an investor to choose and adjust the timing of investments within a portfolio to match current and future income needs. Of course, laddering is just one of many investment approaches. A financial planner or investment professional can help analyze each particular financial situation and adopt a strategy that is best for an investor’s needs. |
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