By Karen Veraa, CFA
With interest rates increasing in 2022, many investors are looking to navigate the market and not lose money on bonds. Bond prices typically fall when interest rates rise. One strategy is to buy a bond and hold it to maturity. Another approach is bond laddering. Bond laddering is the practice of buying bonds that mature in consecutive calendar years and then reinvesting proceeds from bond maturities into new bonds that extend out the ladder.
For example, instead of buying a single five-year bond and holding it to maturity, consider building a five-year ladder with bonds that mature each December for the next five years. When one bond matures, a new five-year bond is purchased with the proceeds (see illustration). Bond laddering potentially provides investors with stable cash flow. Each year, new money from a maturing bond and the semi-annual coupon payments from the bond can be reinvested.
The ability to manage exposures on a yearly basis can be especially beneficial in a rising rate environment. As interest rates change, each bond in the ladder should have a similar total return as the average yield at time of purchase. By locking in a yield at the beginning, the ladder may help insulate the bond buyer from price losses if the investor holds to maturity.
As with a lot of things, however, this strategy is simple in theory but can be more complicated in practice.
The first challenge is selecting the bonds. Should you go only to an issuer that you know? The highest-yielding bond? Or the one with the best credit rating? Researching the credit quality of the issuer requires access to information and the know-how to evaluate relative value between bonds. Even for experienced investors, this can be daunting.
Once you've decided to purchase a bond, consider the transaction costs. Many bonds have minimum sizes to buy and trade. If you don't have a large amount of money to invest, the ability to diversify and spread credit risk across multiple issuers can be difficult. As a result, you might end up with a concentrated portfolio from only just a handful of bond issuers.
Liquidity, or the ability to convert the bond into cash, can be challenging for holders of individual securities. If you want to sell a bond prior to maturity, you'll need to find another buyer in the over-the-counter bond market, which might take time. If your bond has a call feature, you could get repaid early if the issuer decides to refinance its debt. In that case, you face reinvestment at lower yields.
Many investors use mutual funds and exchange-traded funds (ETFs) to overcome some of these hurdles. Traditional funds usually hold a diversified portfolio of bonds and have a portfolio manager who oversees the fund. Because traditional funds don't have maturity dates, the investor would need to sell a portion of the fund if they wanted to take money out of the strategy.
Term-maturity bond ETFs, such as iShares iBonds, can help investors build more efficient bond ladders by combining the reinvestment control of individual bonds with the convenience of an ETF.
Going back to our example of the five-year bond ladder, an investor could purchase five iBonds ETFs and gain exposure to hundreds of underlying bonds with known maturity dates, an income stream designed to be predictable, and an overall experience that's simple and low-cost.
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Carefully consider the Funds' investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds' prospectuses or, if available, the summary prospectuses, which may be obtained by visiting the iShares Fund and BlackRock Fund prospectus pages. Read the prospectus carefully before investing.
Investing involves risk, including possible loss of principal.
The iShares® iBonds® will terminate in the month and year of each Fund's name. An investment in the iShares® iBonds® ETFs ("Funds") is not guaranteed, and an investor may experience losses, including near or at the termination date. Unlike a direct investment in a bond that has a level coupon payment and a fixed payment at maturity, the Fund(s) will make distributions of income that vary over time. In the final months of each Fund's operation, as the bonds it holds mature, its portfolio will transition to cash and cash-like instruments. As a result, its yield will tend to move toward prevailing money market rates (or, in the case of the municipal iBonds ETFs, tax-exempt money market rates) and may be lower than the yields of the bonds previously held by the Fund and lower than prevailing yields in the bond market. As the Fund approaches its termination date, its holdings of money market or similar funds may increase, causing the Fund to incur the fees and expenses of these funds.
Following the Fund's termination date, the Fund will distribute substantially all of its net assets, after deduction of any liabilities, to then-current investors without further notice and will no longer be listed or traded. The Funds' distributions and liquidation proceeds are not predictable at the time of investment and the Funds do not seek to return any predetermined amount.
The rate of Fund distribution payments may adversely affect the tax characterization of an investor's returns from an investment in the Fund relative to a direct investment in bonds. If the amount an investor receives as liquidation proceeds upon the Fund's termination is higher or lower than the investor's cost basis, the investor may experience a gain or loss for tax purposes.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.
Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.
There may be less information on the financial condition of municipal issuers than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Some investors may be subject to federal or state income taxes or the Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable.
An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency and its return and yield will fluctuate with market conditions.
Diversification and asset allocation may not protect against market risk or loss of principal.
There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.
Buying and selling shares of ETFs may result in brokerage commissions.
This material represents an assessment of the market environment as of the date indicated; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual's financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial professional before making an investment decision.
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This post originally appeared on the iShares Market Insights.
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