The Logic Behind Ladders

The Logic Behind Ladders

OCEAN CITY – The recent extreme market volatility
only drives home the difficult choice faced by fixed income investors these
days. They can join the flight to the safety of short-term U.S. Treasury bonds
and give themselves the flexibility to jump back into stocks once things have
settled down — and live with yields that have sunk to .25% or even
less. Or they can try to maximize yields by at least buying bonds and CDs with
maturities of 10 or 20 years. But then they risk having to sell the bonds for a
loss if they want access to their money anytime during a period when most
observers believe interest rates will rise.

But there is a way to have your rates and your
liquidity too. By laddering bonds and CDs, investors can capture higher yields
while maintaining ready access to cash. "A ladder allows investors to
achieve a balance of yield and flexibility," says David Hargarten,
Managing Director of Cash Management Solutions, Wealth Management Banking at
Merrill Lynch. "You can easily convert regularly maturing CDs and
bonds into cash as you need it, and still get additional yield from owning
longer-term issues."

Laddering a fixed income portfolio simply
involves purchasing an assortment of bonds or CDs that mature at different
intervals. As each matures, you can use the cash for other investments or
expenses — or keep the ladder going by reinvesting the principal in a
new, similar instrument that pays competitive interest rates.

Bond ladders work especially well when interest
rates rise, as they’re predicted to do. Earlier this spring, the U.S. Office of
Management and Budget forecast that the benchmark 10-year U.S. Treasury note
would remain below 4.0% for the rest of 2010, but then rise to 4.5% in 2011 and
5% in 2012. "As rates rise, look for the value of bonds to fall,"
says Thomas Latta, Managing Director, Investment Management and Guidance,
Merrill Lynch Global Wealth Management.

Investors who need to free up cash in such an
environment by selling their bonds before maturity frequently take a
considerable hit. In a bond-ladder strategy, however, an investor does not sell
bonds when rates rise. Instead, investors take rising interest rates and
falling bond prices and turn them into a plus by reinvesting coupons and
proceeds from maturing bonds into new bonds that now cost less and yield more.
Overall portfolio values may still decline, but yields are increased over the
long term.

Someone financing a specific goal, such as a
child’s education, might also build in other rungs timed to mature at a
specific point in the future. For example, parents could ladder so-called
zero-coupon bonds of maturities that each correspond to a different year when
they’ll need the cash to pay tuition. As the name implies, zero-coupon bonds
come with no annual or semiannual interest payments. Though that’s less of an
issue when targeting a big future expense like a college education, it allows
purchasers to buy zero-coupon bonds at a discount of their "par," or
redemption value. The bond’s full yield, in other words, is realized upon
maturity — which in this case could be timed precisely to when each
tuition bill comes due.

Those approaching retirement age might adopt a
different strategy. With guaranteed income now a primary concern, they could
structure ladders of bonds and CDs that generate enough in yearly coupon
payments to provide regular cash flows while still capturing the highest
possible yields. One other factor to consider when building your ladder is something
known as the "yield curve" — or the difference in yield
between short- and long-term rates in the bond and CD market. Although it’s
flattened out a bit in recent weeks, the yield curve is still currently steeper
than it’s been in decades, another sign that rates are likely headed up. That
means investors may want to give even more consideration than usual to
very-short- and very-long-term laddering strategies: buying bonds at the far
end of their ladder to lift overall yields, but also making sure their
liquidity needs are met to minimize the chance that bonds will have to be sold
before they mature.

(A Merrill Lynch Wealth Management Advisor. She
can be reached at 410-213-8520.)