Rising interest rates are playing on the minds of many fixed income investors. Increase in interest rate leads to correction in bond prices. Long-term bonds are more sensitive to this. No wonder, some investors are sticking to short duration bonds. But you are in a dilemma – if you remain invested in short-term bonds, then interest rate risk is low but yield is also lower; if you invest in long-term bonds, then you can earn higher yield but you are also exposed to higher interest rate risk. So, is there a way out? The answer is laddering.
What is laddering
Simply put, laddering means investing in bonds with varying maturities. Investor invests in bonds maturing from one year to ten years or more. For example, if you have ₹10 lakh to invest in fixed income, then you can invest ₹2 lakh in bonds or target maturity funds (TMF) maturing in one year. The next ₹2 lakh is invested in bonds or TMFs maturing in three years and some allocation is made to those maturing in five, seven and ten years. Each of these offer different yields and you get a decent average yield on your overall portfolio, as you hold on to each investment till its maturity.
Interest rate risk control
When you hold on to each investment till maturity, the impact of mark to market movements is nullified. You receive your principle back along with interest. The first TMF matures in next year or two. And the money can be invested in a 10 year TMF then. The yields available will be higher if the interest rates are rising, which benefits the investor. If interest rates fall, then the investor has to go for a lower rate of interest but his existing investments continue to earn the relatively higher rate of return. Each time a bond matures, the investor gets an opportunity to invest at a different level of interest rate.
Since you are investing at different points in time, you are neither investing all your money at the peak of the rate cycle nor at the bottom of it. It is like buying stocks at various points of time. Over a period of time you average it out and take money home. The interest rates may keep changing, but you need not worry about it.
Laddering also helps you to build a fixed income portfolio that offers intermittent liquidity. Every 2-3 years one of your investments mature. The cash reaches your bank account. This can be a wonderful method to plan for financial goals.
Laddering can be attractive today – when interest rates are at a lower end and may rise. Though it can help you avoid locking in all your money for long duration at a low rate, do not ignore your financial goals or cash flow requirements. If you invest your money in varying maturities of up to 10 years and you need money in the near term, then you will suffer from cash–flow timing mismatch. Hence, marry your investment timeframe with the maturities of the TMF . If you have a five year timeframe then invest in bonds or TMF maturing in 1-2-3-4-5 years and if you have 10 years, then consider investing in bonds or TMF maturing in 1-3-5-7-10 years.
Laddering can help you invest in the fixed income space without fear and you make a reasonable rate of return.
The author is Head – Product, Marketing and Digital Business, Edelweiss MF