Which way are rates headed?
Maybe you've had this dilemma. You want to invest in fixed income securities to provide income. Your choice is a long-term bond at 8% (1) or a shorter-term bond at 6%.
You wonder what if interest rates rise? Then you'll be stuck in these bonds and you won't be able to get out in order to get higher rates. So you buy the short-term bond.
But what if interest rates fall? Then you'll be sorry that you did not buy the longer-term bond and lock in a higher rate. What should you do?
Many investors have used the ladder approach. For example, they will divide their income investment portfolio into parts, each representing a rung on a ladder. They buy a 1-year bond, a 3-year, a 6-year, a 10-year, a 15-year, a 20-year and a 30-year bond. Generally, the longer-term bonds will pay the highest rates. The longer-term bonds lock in higher rates and provide a defense to interest rates going down. However, if rates rise, then when the one-year bond matures, it can be reinvested at the new higher rates and so can the other shorter-term bonds as they mature. This ladder serves to remove this dilemma and hedge changes in interest rates in either direction.
Will this give you the absolute best return? The only way to get the absolute best return is only by knowing the future of interest rates. And if you think you'll get that insight on CNBC or from your newspaper business section, dream on. These "experts" are merely guessing.
The logical and sensible solution is the ladder. These bond ladders can be constructed with treasury securities, corporate bonds and municipal bonds. If you'd like to learn more about preserving your interest income, check off on the coupon for a ladder illustration.
(1)- rates are hypothetical and used for concept illustration only