A portfolio of individual bonds can provide constant, dependable income both now and in the future. Now that we’re in an environment of rising interest rates, it’s more important than ever to develop a bond portfolio with flexibility so investors can optimize their income stream.
An overarching strategy for bonds is to stagger their durations so you have periodic opportunities to re-assess investment options when each bond matures and the principal is repaid. The last thing you want is for all of your bonds to mature around the same time, because you may get stuck reinvesting your principal at lower interest rates. To prevent this, consider the following bond strategies.
When you “ladder” a portfolio of bonds, you purchase a variety of short-term, intermediate-term and long-term bonds. As each bond matures, you can evaluate your next move based on the current state of interest rates. When they’re low, you might want to reinvest in longer-term bonds, which generally provide the highest yields. When interest rates are high, you have more options available depending on what your portfolio needs, but it’s a good idea to continue diversifying maturities so you retain flexibility. Laddering is generally an appropriate strategy for an investor who can commit a significant amount of funds over a long-term timeline.
For example, say you purchase a two-year, a four-year and a six-year bond at the same time. Two years later, interest rates have increased, so you reinvest the first bond for a six-year duration. Two years after that, you take the principal from the second bond and invest for an eight-year duration. Two years later, you re-invest the third bond for a 10-year duration. Thereafter, you re-evaluate the bonds as they come due and continue to pursue a laddered duration strategy. If you remain diversified, you should be able to reinvest principal every two to four years, which provides the opportunity to frequently re-evaluate your needs and the interest rate environment.
When you purchase a combination of short- and long-term bonds, but eschew intermediate-term bonds, you create a Barbell Strategy. Here too, you can re-evaluate the direction of interest rates at different time periods while at the same time taking advantage of the higher rates of longer-term bonds. The Barbell Strategy provides a degree of liquidity since the investor receives back a portion of his assets every few years when the short-term bonds mature. It’s a sound solution for people with long-term income needs who also want regular access to funds for short-term goals, such as paying for college or buying a new car.
The Bullet Strategy is appropriate for an investor who knows exactly when he needs his income, such as the year he plans to retire. In this scenario, he buys a series of bonds all scheduled to mature in that year. However, to achieve diversity and the flexibility to reinvest at potentially higher rates, this bond investor staggers when he purchases the bonds. First he purchases long-term bonds, then a few years later he purchases intermediate-term bonds, and then finally a little further down the road he buys short-term bonds. Each bond will mature in the same year, but the investor keeps a cash cushion on hand and waits for the optimal interest rate option to make subsequent purchases.