Interest rates have been upside down for quite a while now, as the yield curve's current state of inversion has persisted throughout much of 2006. Since the Fed's interest rate hike in June, short-term rates have hovered around the 5% level, while longer-term rates have stayed in a range between about 4.5% and 5.25%. At least for now, you can't earn any reward for being willing to give up liquidity for longer periods of time. Conflicting economic reports make it unclear whether or not the Fed's next move will be to raise rates further or begin to lower them in anticipation of a possible recession.
With the current uncertainty about the future direction of rates, some strategies that bond investors use to maximize returns no longer look as attractive as they once did. In particular, using a bond ladder for your fixed-income allocation seems at first glance to be just throwing money away. However, you should think carefully before you choose to abandon this simple yet successful method of saving.
Basics of bond ladders
A bond ladder involves investing in a number of bonds, each of which has a different maturity. For instance, one commonly used bond ladder has investors choose different maturities between one and five years from the time they begin investing. To set up the bond ladder, you divide the money you want to invest into five equal amounts and then buy five bonds -- one that matures in one year, another in two years, and others in three, four, and five years. A year from now, when your one-year bond matures, you invest the proceeds into a new five-year bond. Meanwhile, your other bonds each have one less year to go before they mature, so your maturity range looks exactly the same as it did when you first started. The benefit of using a bond ladder is that it helps to smooth fluctuations in interest rates. Rates can change significantly over the course of a year or two, and many investors who rely on regular income payments on their fixed-income securities for living expenses can't afford to have their income fall dramatically. In addition, bond ladders allow investors both to retain some short-term liquidity while still reaping the benefits of higher rates on longer-term bonds.
When rates aren't normal
That last sentence assumes that rates on longer-term bonds are actually higher than the rates paid on their short-term counterparts. Currently, however, that isn't the case. In the Treasury market, you can get a higher yield on a six-month maturity than on any other Treasury security. Similarly, according to Bankrate, the banks that are currently offering the best rates on certificates of deposit have better rates for short-term CDs than for investments over several years. Netbank
However, the inverted yield curve won't last forever. In the past, short-term rates have only exceeded long-term rates for a brief time before returning to their more usual relationship. Once the yield curve turns back over, those who stuck with their bond ladders may see why it was a good idea.
Short-term greed, long-term pain
The last time the yield curve was inverted was in 2000. Long-term bond rates were at about 5%, while the federal funds rate was at 6.5%. At the time, it was relatively easy to find teaser rates for short-term CDs at 7% or more. Fixed-income investors could get a big increase in their income just by keeping things liquid. It seemed like free money.
In 2001, though, short-term interest rates plummeted as the Fed cut rates numerous times, eventually reducing the federal funds rate to 1% by 2003. Short-term Treasury bill yields fell below 1%, and investors who had taken advantage of high interest rates found themselves having to reinvest their money at much lower rates.
Today, 4.75% may not seem like a very good deal for a 10-year Treasury note. However, if short-term rates again fall significantly, it won't take many Fed rate cuts to make you long for the days when you could get that high a rate on your savings. Similarly, even if 5% doesn't seem like enough compensation for a five-year CD, it might help you avoid having to accept 2% or 3% on a CD in the near future. If investors in late 2000 had put some of their money into longer-term CDs, they would have weathered most of the decline in interest rates and only now would have the money from those maturing CDs to reinvest.
Even though short-term rates currently offer attractive investment opportunities, you shouldn't give up on a profitable long-term strategy just for the sake of temporary gain. Even though you might make a little more money now by giving up your bond ladder, you might well find that you lose much more in the future as a result. Keeping a bond ladder is a good way to keep your interest from your fixed-income portfolio relatively stable.
Bonds are an integral part of the portfolios of many investors. To understand bonds and other fixed-income securities better, be sure to check out the Fool's Bond Center. You'll find helpful information, definitions, and commentary about how you can use bonds as part of a successful investment strategy.
Only three days left in this season's Foolanthropy campaign! Visit www.foolanthropy.com to learn about five reader-nominated charities and make a donation.