At the moment, bonds pay a pathetic amount of interest. This is true in New Zealand where a New Zealand government eight-year bond pays only about 3.5 per cent a year and overseas where, even worse, a US government 10-year bond yields just 2 per cent.
These low rates have of course been provoked by the global financial crisis - yields have been pushed down hard to try to get some economic growth. That's great for borrowers, but not so good for those of us on the other side of the coin - investors.
These low rates create a dilemma for income investors and others who need to have bonds in their portfolios. Eight years is a fairly long time to be in an investment and the chances of an interest rate hike that would leave you stranded with a fixed rate of 3.5 per cent are fairly high. It is quite possible that this rate hike might come fairly soon so, should investors lock their money away and commit themselves for years to such a pitiful interest rate? Probably not.
There are a number of things that an investor can do when faced with over-heated, low yielding bond markets: None of them a great solution to the need for dependable income. First, you could look for high-yielding shares or property trusts instead of bonds (not a very good solution because even the very best shares will give you increased volatility and less certain income). Second, you could try to get higher yields with bonds from poorer rated issuers (again, a poor idea: it was this thinking that drove people into finance companies with disastrous results).
Third, you might decide to wait until bond yields rise and simply hold cash in the meantime (a better solution, but you will have lower income from short-term deposits and there is no certainty of income). Fourth you might buy perpetual bonds whose interest rates are reset every five years (yes, but the time when your bond is due to be reset may not coincide with an increase in interest rates).
There may be other things that you could consider as well but, like the four things above, none is a perfect solution and all have their own risk. One of the key things about bonds is that they ought to give certainty of income for some years and no other investment type can replace that key attribute.
Perhaps the best thing that you can do with bonds at a time like this is to ladder them - that is, to buy a number of different bonds, each with different maturity dates. Laddering bonds is to build a portfolio which has some bonds that will mature in eight years, some in seven years, some in six years etc. Over time, the bonds at the top of the ladder (the longest dated ones) will slide down as they get closer to maturity and, when they mature, the proceeds are used to buy bonds at the top of the ladder (that is, the longest maturity).
At the moment, we have a positive yield curve which is a flash way of saying that the longer the maturity date of a bond, the higher the interest rate.
For example, a TrustPower bond which matures in 2014 pays an interest rate of 4.9 per cent while a bond from the same company that matures in 2017 pays 5.5 per cent.
Clearly, you want to be buying longer-dated bonds to get the higher interest rate but if all of your bonds are longer maturing, you run the risk of locking up your money for a long period at current low interest rates. Also, if they all mature at about the same time, it could be that when you reinvest, it is a time of low interest rates.
To lower these risks, you should, therefore build a bond portfolio with a range of maturities and so each year only a few bonds will mature.
The proceeds from these maturing bonds can be used to buy bonds which are long maturity (at the top of the ladder). As time passes, these bonds will move down the ladder, mature and then be replaced by long-dated bonds.
Laddering a bond portfolio means that at all times you are able to buy longer-dated (and, therefore higher-yielding) bonds and at the same time you will never be too far away from having some of your bonds mature. This gives you the best of both worlds: the highest interest rates but with a range of maturities.
Martin Hawes is an authorised financial adviser and his disclosure statement is available free of charge at www.martinhawes.com. This article is of a general nature and no substitute for personalised financial advice.
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