As the stock market continues to defy gravity and interest rates remain very low in 2020, it’s tempting to think there is no place that’s better to stash your cash than in U.S equities.
After all, with the S&P 500 index of large-cap stocks up nearly 20% in the last 12 months, while 10-year U.S. Treasury bonds yield less than 0.8% annually, it’s hard to justify a portfolio that isn’t heavily invested in stocks right now.
That said, the old saying that “past performance is no guarantee of future returns” is important to remember in times like these. Furthermore, while bond investing is admittedly out of favor right now, the strategy of investing in fixed-income instruments remains a crucial part of any well-rounded, long-term portfolio that seeks to reduce risk and protect your nest egg.
[Read: The Ultimate Guide to Bonds.]
But even investors who are interested in bond investing shouldn’t simply dive into this corner of Wall Street without forethought. Particularly in the current low interest rate environment, there are real risks to acknowledge in bond investing. The most obvious of these is the fact that when interest rates rise, bonds lose value — so if you’re actively trading bonds, your modest income potential could be more than offset by principal declines if and when rates move higher.
How can you invest responsibly in bonds, with an eye toward reducing your risk in the long-term? A bond ladder could provide the answer for many investors:
— What is a bond ladder?
— Bond ladder exchange-traded funds.
What Is a Bond Ladder?
The term ” bond ladder” has traditionally been used to refer to a portfolio of individual bonds that mature at different dates.
For instance, a 10-year bond ladder might have 10 different 10-year bonds, with each one maturing in one-year increments that span 2020 to 2030. Then, when the individual 2020 bond reaches full maturity this year, an investor would step off that “rung” in the bond ladder portfolio and put a new 10-year bond on top maturing in 2031.
This approach is appealing to fixed-income investors for several reasons.
The first is the obvious benefit of diversification, by making sure you’re invested in several securities instead of just one or two investments. This diversification is particularly pronounced when you take the long-term approach of a bond ladder that regularly reinvests your nest egg across an ever-changing debt market over many years.
After all, just as it’s risky to attempt to “time” the stock market and go all-in at what you think is the bottom, it’s equally challenging to predict how the interest rate environment will evolve. Buying into bonds at different moments in time helps smooth out performance and reduce your risk.
Perhaps most importantly for investors at or near retirement is that there is also built-in liquidity to building a bond ladder portfolio.
In the aforementioned 10-year bond ladder, every 12 months you can expect 10% of your portfolio to come back to you as cash when the investments reach full maturity. You can reinvest to keep the ladder going, if you desire, or you can choose to let the money roll off and back into your pocket if you need the cash.
There’s no risk of losing principal value on your bonds this way, as you are simply getting your initial investment returned upon maturity rather than selling an active bond to another investor at either a premium or a discount based on market conditions. This takes some of the guesswork out of whether you should sell or keep holding, as you are free from principal fluctuations.
Particularly if you’re looking at a long-term, low-risk investment plan, there is significant appeal in a bond ladder strategy.
Bond Ladder ETFs
If you like this idea of bond ladder investing in theory but are turned off by the notion of buying individual bonds and managing this bond ladder on your own, take heart.
In 2020, thanks to the proliferation of many tactical ETFs that have unlocked strategies that were once out of reach for individual investors, there are ways to simplify this process using exchange-traded products.
Two of the most prominent flavors of bond ladder ETFs are so-called “term maturity” funds offered by leading investment managers iShares and Invesco. Both the iBonds family offered by iShares and the BulletShares family offered by Invesco provide variety in bond types as well as maturity dates.
For instance, the iShares iBonds Dec 2021 Term Treasury ETF (ticker: IBTA) invests in U.S. Treasury debt that matures by the end of 2021, while the iShares iBonds Dec 2021 Term Muni Bond ETF ( IBMJ) is comprised only of local government debt instead of Treasuries. Meanwhile, the Invesco BulletShares 2021 USD Emerging Markets Debt ETF ( BSAE) is only debt from emerging markets that matures in 2021, while the Invesco BulletShares 2021 High Yield Corporate Bond ETF ( BSJL) also matures in 2021 but is instead focused only on “junk” bonds from distressed corporations.
The full list of funds is far too broad to list here, with various segments of the bond market represented across various maturities. But all of them function in a similar fashion by providing a diversified basket of bonds within each maturity window; for instance, BSJL holds nearly 80 different bonds in its portfolio at present. They also function just as traditional bond investments, offering steady income payments across their life before returning their asset value back to investors at maturity.
The drawback, of course, is that even these easy-to-trade bond ladder ETFs are not truly a ” set it and forget it” strategy. Once they mature, it’s up to you as an individual investor to decide where to move that money next or whether to simply hold on to the cash.
It’s also worth noting that no investments are truly risk-free. Even low-risk U.S. Treasury bonds can see fluctuations in value, particularly if you are forced to exit those positions before they reach maturity.
That said, bond ladder ETFs are an intriguing way to unlock income potential and lower your risk profile over the long term.
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