Long-Term Strategy (20-30 year maturity)
- Advantages: Long-term bonds have the highest yield.
- Disadvantages: Greatest erosion of principal exists when interest rates go up. If interest rates drop, they have the least upside potential because call features will inhibit upside movement.
- Why people do it: Income motivated.
Intermediate Strategy (10-20 year maturity)
- Advantages: Relatively high yield.
- Disadvantages: Some erosion of principal if interest rates go up.
- Why people do it: Intermediate bonds sacrifice very little yield over long-term bonds while reducing principal risk.
Short-Term Strategy (1-5 year maturity)
- Advantages: Even if interest rates go up dramatically, the value drops little, if at all.
- Disadvantages: Usually has the lowest yield.
- Why people do it: Liquidity of principal and minimum exposure of interest rate fluctuations.
Premium Strategy (purchase price higher than par)
- Advantages: Maximum tax-free income. Value.
- Disadvantages: More money is invested up front. Not as marketable as par bonds (if you sell).
- Why people do it: Greatest income with highest yield and lowest volatility.
Discount Strategy (purchase price lower than par)
- Advantages: Buy more bonds for your money. If interest rates decline, discount bonds have the highest potential to increase in value.
- Disadvantages: Current yield is lower than current coupon bonds. If interest rates rise, discount bonds have the greatest potential decrease in value (unless you hold the bonds to maturity).
- Why people do it: Do not need all current income now. Built-in annuity. Greatest upside potential if playing interest rates.
Laddered Portfolio Strategy
- Advantages: Protects you no matter which way interest rates go. Diversification of maturity, price, geography, type, and quality.
- Disadvantages: It is the average of everything.
- Why people do it: You want to play interest rates; you do not want interest rates to play you. You want a hedge against interest rates.
- The Process of Creating a Ladder
- Purchase an equivalent number of bonds maturing every year for the next twenty years.
- Notice that a percentage of the portfolio is invested in short-term maturities (liquidity) while the remainder is in intermediate and long-term maturities (higher-yields). Further, both premium and discount bonds may be purchased. Thus, the five previous strategies are incorporated in the Laddered Portfolio. Finally, with as many as twenty securities in the portfolio, diversification as to geography, type and quality can all be achieved.
- When the 2004 bond matures, you reinvest this amount in the next available year, which is 2024. As 2005 matures it is reinvested in the next available year, 2025: 2006 in reinvested in 2026, etc.
- As long as you keep this structure alive, 25% of your bonds will always be due in five years or less, and in case of an emergency, you can liquidate 25% of your portfolio with little or no erosion of principal.
- If interest rates go up , the yield on the portfolio will rise as proceeds are reinvested. If interest rates remain the same, your portfolio yield will still go up because you have reinvested your shorter-term bonds in longer-term, higher-yielding bonds. If interest rates come down, you have much of the portfolio locked into high-yielding bonds.
Explanation of Terms
- Maximum tax-free income: An investor is compensated for paying a premium in the form of additional tax-free interest income.
- Value: Retail demand is often weak for premium bonds due to investor reluctance to pay more than face value of a bond. With reduced demand comes a higher yield.
- Kicker: Lower prices are available on bonds priced to their call on the assumption the bonds will be called with a bonus of extra yield if the bonds are not called.