The Practical Investor — Capturing higher bond yields at lower risk

In Part 1 of this series, the authors emphasize practical investment strategies that readers can employ immediately.

by Marvin Appel, Ph.D. and Brian Hufford, CPA, CFP

When comparing stocks to bonds, it's impoortant to remember:

• Bonds provide an ongoing and predictable stream of income via interest payments, whereas most stocks now provide a minimum dividend payout (approximately 1.3percent for companies represented in Standard & Poor's 500 Index), investment returns that are largely dependent upon rising stock markets and capital appreciation.
• If you invest in a diversified portfolio of investment-grade corporate and/or government bonds and hold them until maturity (when the issuer repays in full the face amount of the bonds, usually $1,000), there should be minimal risk to your initial investment.
• Total returns from bondholding have been generally less than returns from stock ownership over the long run, but are more predictable. Bonds should probably represent an increasing portion of portfolios as investors become older and capital preservation assumes increasing priority.
• The longer the maturity of the bond, the higher the yield, but the more subject the bond value is to interest rate fluctuations. Longer-maturity bonds (bonds that have a scheduled repayment of principal more than 15 years distant) are more subject to price fluctuation than bonds with a closer maturity.

Investors must therefore choose between lower rates of return that near-term bonds offer and the higher risks associated with long- term bonds.

Best of both worlds
Here is a way to establish a program that provides your bond portfolio with interest rates associated with long-term bonds, at levels of risk associated with bonds of shorter duration.

First, establish a laddered portfolio of bonds — a portfolio equally divided among bonds of different maturities, evenly spread. For example, suppose you were to create a portfolio of corporate bonds going to a maximum maturity of 15 years. It might look something like this:

At the end of three years, during which time you will be receiving the above rates of interest, the shortest-term three-year bonds will have matured and your principal returned to you. This principal is then reinvested in new 15-year bonds that we presume are still paying 7.1 percent. In the meantime, the bond you purchased with an original six-year maturity will now have only three years left to its maturity. The original nine-year bond will have become a six-year bond and so forth.

Your portfolio would now look like this:

Length of Maturity / Interest Return

3 years remaining —5.9%
(original 6-year bond)

6 years remaining — 6.3%
(original 9-year bond)

9 years remaining — 6.7%
(original 12-year bond.)

12 years remaining —7.1%
(original 15-year bond.)

15 years remaining —7.1%
(new 15-year bond.)

At the next three-year interval, the shortest term bond will be redeemed and the capital reinvested in a new 15-year bond. Your portfolio would now look like this:

Length of Maturity / Interest Return

3 years left — 6.3%
(original 9-year bond.)

6 years left — 6.7%
(original 12-year bond.)

9 years left — 7.1%
(original 15-year bond.)

12 years left — 7.1%
(original 15-year bond purchased last cycle.)

15 years left — 7.1%
(The new 15-year bond.)

When the cycle is complete, you will end up with all of your holdings paying 7.1 percent, the rate of interest paid by long-term 15-year bonds. The average maturity of bonds in your portfolio, however, will have a life of just nine years, but will be earning interest at the rate of 15-year bonds.

At all times, after the initial purchase, you will be receiving income that is proportionately higher than the risk level of your portfolio. Nine-year bonds provide a yield of 6.3 percent. Your final portfolio, which averages nine years in maturity, will be providing a yield of 7.1 percent.

This investment strategy, as all others that are successful, involves the establishment of reasonable goals, a consistent strategy for achieving these goals, consistent follow-through, and a longer-term approach to the development of an investment portfolio.

In future articles, we will discuss strategies for long-term mutual fund selection and market timing.