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Ladder of Sophistication "Laddering" is a proven investment style for this type of investment. The principle is simple. You want to keep your money continually invested. To do that, you would buy bonds with different maturity dates often based on two year expiration increments. The idea of keeping your money actively invested saves you from interest rate fluctuations. Having everything you own come due on the various dates, according to the style, takes the chance that when the money is reinvested, it will be reinvested at a more favorable yield.
By owning bonds with maturity dates of two, four, six, eight, and ten years, the selling and reinvesting can take place on a regular basis. For example, when a two year bond matured, the net receipts are used to purchase a new ten year bond. This method keeps the ladder effect even.
It is far more complicated than that simple explanation would make it seem. This investment style comes with many pitfalls for the average investor.
There is the consideration and tracking of credit risk and/or the possibility that the company will default of their bond. That means you run the risk of not getting back what you loaned them. A bond is a promissory note with interest that is set, along with other factors, on the ability for the borrower to pay. The riskier the loan, the higher the interest payment or yield they offer the lender.
Bonds can also come with a caveat. There is always the possibility that the bond comes with call provisions in place. This is similar to a home refinance. A call provision slaughters your return by paying you early what you have due much like a homeowner would do to a lender if they pre-pay their mortgage. Not only does that reduce the return, you are forced to find someplace else to put your money. With any luck, at the same rate of return.
Another thing to consider is the price. Buying individual bonds does not always net you the best price. And the bother of laddering, a seemingly endless task this is custom made for old men with cynical natures. That is not, however a reason to turn away from investing in bonds. The best way to create a fixed income environment with a predetermination of risk, which is part of a diversified portfolio, is to invest in a bond fund.
Bond funds although, are not bonds and are not priced in the same way. While bond funds do provide the investor with diversification, they lack the guarantees of a semi-annual check from coupons (individual bonds pay every six months), a feature the fixed income investor is accustomed to receiving.
Bond funds collect the value of their portfolio, do some quick arithmetic and determine what is called the net asset value. When you buy into a bond fund, this determines the share price. Because this price can change, the value of your principal can as well. With individual bonds, there is no risk that principal can be lost due to falling NAV, net asset value.
Individual bonds however are subject to interest rate fluctuations. For instance, if you buy a bond with a par value or face value of $1,000 and the interest rate is 6% for ten years. You will receive a check every six months for $30. For a full year, you will receive $60 or 6% of the $1,000. The par value does not change. The interest is paid to maturity and when that point in time occurs, you get your money back to reinvest.
If the interest rate environment changes and the cost of borrowing has increased, your bond may be worth less. Here's how it works. The bond you own is worth $1,000. But interest rates are rising. This means yields are also rising. And because the yield (or the interest the borrower pays you for the money) is rising, the price of the bond will fall. In order for you to take advantage of this change in yield, say to 8%, you will need to sell your lower yielding bond.
Problem is, in order to unload the bond paying only 6%, you will need to discount the price. So to attract investors you will need to price your bond at a price that will reflect the lower rate. The price of your bond is now worth $750, giving the new bond holder a reason to purchase the bond at the lower than market yield.
Should interest rates fall however, the bond you hold at 6% becomes more valuable. Investors will want the higher yield and because of that will pay a premium over par value or the original price you paid for the bond. If rate fall to 4%, the value of your bond will jump to $1,500.
Laddering, buying bonds at different time during different rate environments usually offsets this type of buying/selling/chasing the best deal problem. For the average investor, the bond fund is perfect.
Bond funds do come with certain costs that are present in all mutual investing situations. Some one has to run it, do all of the laddering and such, and the cost of that needs to be added to the cost or subtracted from the return on investment. Lack of transparency in the fund's holdings or the ability to have access ot full disclosure makes the truly sophisticated investor shy away from funds. Even if the "cons" of owning bonds in a fund more or less stop right there.
Professionally managed bond funds are less sophisticated but that is a small sacrifice for the good they provide individual investors looking for a safe haven. Fund managers are able to not only buy bonds at a better rate than individuals can, but their research into call provisions and creditworthiness far exceeds that of the average investor. This pricing structure is very important to the success of the bond fund.
Bond prices are set a percentage of their redemption value. This is called par and the value is set at 100. The individual may buy a bond for an eighth or a quarter point below par and believe they have received a good price. The bond fund manager may buy that same bond for 4% below par.
This is, in essence, how fund managers justify their fees. The spread they receive usually offsets any fees. Fund managers often tout their ability to be flexible. Bonds are not stationary investments and these funds can have some action.
Interest rate fluctuations are murderous on an individual investors attempting to ladder their fixed income investment. The par value can work against the individual. When an investor sells at maturity, they are often left with the problem of repurchasing. Often these options can be limited.
The skill of a bond investor lies mostly in their ability to get good par value. A repurchase schedule doesn't take into consideration par value. Fund managers can look for opportunities in-between those maturity dates, outpacing the individual's ability to do as well.
Fund managers are more in tune to the possibility of callable bonds, the ones whose issuers can redeem and then reissue those same bonds at lower interest rates. Individuals who invest in bonds will often take this possibility into consideration and avoid these types of provisions. This strategy however passes over some great opportunities.
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