The Federal Reserve has been on an interest-rate cutting spree that began with a surprise cut to a benchmark rate late last summer. There were other surprise reductions to the federal funds rate and the discount rate, including two of the largest rate cuts in decades.

These interest-rate cuts were accompanied by troubles in the credit market, slowing economic growth, and rising inflation. For some investors who owned bonds that matured during this period, it was a tough time to reinvest principal.

Fortunately, there is a way to spread the interest-rate risk associated with bonds so that they all won’t mature during a period when reinvesting conditions are less than favorable.

Spread Out
One of the more appealing aspects of investing in long-term bonds is the opportunity to hedge against short-term risks. A bond is an agreement between a borrower and a lender. The interest rate and maturity date are theoretically fixed. Assuming that the investor doesn’t want to trade or sell the bond before it matures, the only interest-rate volatility that matters is the economic environment when it’s time to reinvest the principal.

So it follows that owning bonds with maturity dates that are spread out can help limit reinvestment risk. This strategy, known as bond laddering, involves building a portfolio of bonds with varying maturity dates, such as four years, eight years, and ten years. If rates are low when one bond matures, only a portion of the portfolio’s income is exposed to reinvestment risk. If rates are high when the next bond matures, the investor has the opportunity to reinvest a portion of the portfolio at the higher rate.

The principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investments seeking to achieve higher yields also involve a higher degree of risk.

Bond investing is an important strategy for pursuing income and long-term stability. Building a bond ladder can help protect against the inevitable interest-rate risks of bond investing.

This material was written and prepared by Emerald Publications.
© 2008 Emerald Publications