Rick: Hi. Welcome to Market Thoughts. I am Rick Zich, an advisor here at Southwest Investment Advisors. Joining me is Bart Schannep, cofounder and president of Southwest Investments. How are you doing Bart?
Bart: I’m good Rick.
Rick: Excellent, excellent. I was speaking to a client the other day. I was going to be recommending a bond ladder, and the lights went out. Not a clear understanding about bond ladders. Why don’t you dig into bond ladders for us?
Bart: Well, it’s been a long time since people have been buying bond ladders. In an interest rate environment like we’ve had for quite a few years now of interest rates falling, it’s always made sense to simply buy the longer bond maturities to lock in the rates as rates kept falling. Well, now we’re at the point where interest rates are very, very low. Now, we’ve said this before. How low can they go? It’s amazing how low they can go.
Rick: That’s right. We weren’t expecting two cuts this year but there’s…
Bart: No, but here they are.
Bart: Now, where are interest rates going to go from here? Well, really only one of two directions, either stay the same or go up. How does one position oneself with a fixed income portfolio in a rising interest rate environment? A timeless strategy is to use a bond ladder.
As an example, you can see on the screen. If we were to take a $50,000 portfolio and divide into five $10,000 bonds maturing in one year, two year, three year, four year and five year, as you can see on the left of your screen, interest rates, and I know the interest rates that are being shown are not available in today’s world. It’s simply for demonstration. What you can see is the longer you go out, the higher the rate of return.
Then as the first bond matures, as the one-year bond matures, we then buy a new five-year bond. The next year, when that 10,000 matures, we then buy a new five-year bond. Well, what happens? Well, over time, we end up with the five-year bond yield and yet we have a bond maturing in one year, two year, three year, four year and five year.
In other words or in simple terms, at the two-and-a-half-year mark is our average maturity and yet getting the five-year yield. The advantage of doing a bond ladder in a rising interest rate environment is every time you buy a new bond, you’re buying it at hopefully after rates have risen. You keep buying better and better returns.
Rick: Well, thank you for that insight, Bart. I really appreciate it, and I’m sure our clients do as well. Thank you for joining us. We hope you enjoyed this explanation of bond ladders. We look forward to seeing you next time.