Even in a low interest rate environment, a balanced portfolio should include a portion of fixed income investments to smooth out the peaks and valleys in performance and provide liquidity.
For individuals requiring regular investment income, fixed income investments with their set maturity dates and regular interest payments offer both income and capital preservation.
Interest Rate Risk
Because they are subject to interest rate risk, laddering (or having a variety of maturities) a bond or GIC portfolio reduces the impact of interest rate fluctuations.
Interest rate risk is the risk that interest rates will rise and you will be locked-in to a lower rate. Another risk is if you’ve invested at a high rate, interest rates may be a lot lower when it comes time to renew.
Laddering means splitting your investment over a variety of terms. If for example you have $50,000 and want to invest in GIC’s, you would put $10,000 into terms of 1, 2, 3, 4 and 5-years. This creates a “rolling maturity cycle.”
Every year you will have some money coming due that you will invest in a new 5 year GIC. And since the interest rate is higher for 5-year terms you will always be re-investing at the highest rate.
If interest rates have gone down, only one fifth of your money is immediately affected. If rates have risen, you have the opportunity to take advantage of those higher rates because you have some money coming due. It also gives you some liquidity since you will always have some money maturing each year.
Bonds differ from GICs in that the term to maturity can be as long as 30 years and they can be bought and sold on the secondary market.
When constructing a bond ladder, again you will invest an equal amount maturing successively in each year or several years.
If interest rates start to rise, the shortest-term bonds in the ladder can be reinvested at maturity into longer-dated (and usually higher yield) bonds. If rates decline, the longer maturity bonds will appreciate in value.
If an investor doesn’t have enough capital to build a bond ladder, an alternative is to invest half of the fixed income portfolio in shorter-term bonds and the other half into long-term maturities.
Bonds generally make their payments every six months. If you are looking for a reliable and consistent income stream, build a ladder of at least six bonds that pay their semi-annual interest in different months if possible.
By using this method the bond portfolio can generate income every month of the year.
Ladders average out volatility in a portfolio. Also, bond prices usually build in a premium to compensate for inflation, so continuously adding new maturities to the ladder automatically provides some inflation protection.
Best of all this approach is very disciplined. By dividing your fixed income portion into equal amounts over a range of maturities, you can avoid trying to forecast future interest rates.