A Laddered Bond Portfolio Can Reduce Nausea

Bill Gross is the bond king. He manages the largest actively managed bond fund called Pimco Total Return, with $240 billion in assets. This is one of the first years in a long time that he has underperformed his benchmark. From Jan 1, 2001 through 9/30/2011, his fund is up 1.90%, vs. his benchmark which is the Barclays US Aggregate index (source pimcofunds.com). He made a bet that US Treasuries were going to go down in price and instead, they went up.

Even the “professional portfolio managers” that manage billions of dollars can be wrong, ahem, more than once. That’s why I think you should consider a laddered bond portfolio . . . more of that in a bit.

Today, Bill Gross has come out with a report saying that inflation will eventually come back and he is advising investors to buy bonds with 1-10 year maturities. He sees long term bonds (15 years plus) going down in price.

Everyone I know has been calling for higher rates for the past 5 years. Even my gardener!!! And where have rates gone? Down! That’s right. So many of us lived through the 80s with crazy high interest rates and inflation.

We think the exact same thing will happen again. But the reverse has happened and most of us have been wrong. That means if you are a bond buyer/bond owner, you have taken a major pay cut! Like a big pay cut because you are making less interest because interest rates have gone down. Like a 50% reduction in your cash flow from 5 years ago.

Eventually, there will be higher rates and the talking heads on tv will be right. But when? And how long are you going to sit in cash? That means in money market funds and short term CDs paying 0.25% -1.15% as I write this.

Because interest rates and inflation are so low today, that they only have one way to go – up! Our government is printing money and keeping rates artificially low.

I agree with Bill about buying 1-10 year bonds. The shorter the term of the bond, the sooner you will get your money back, and the less volatile it will be when you hold it.

So . . .take the guesswork out of predicting rates and consider building a laddered bond portfolio. But what the heck does that mean? Right!

Let’s say you have $10,000 to invest in bonds. Here is how you build a laddered bond portfolio:

1) Step 1 – Invest $1,000 in a 1 year bond

2) Step 2 – Invest $1,000 in a 2 year bond

3) Step 3 – continue investing $1,000 in a 3, 4, 5, 6, 7, 8, 9,and 10 year bond.

4) Step 4 – when the 1 year bond comes due, you will need to reinvest that in a 10 year bond – as long as you still want a 10 year strategy

5) Yay! You now have money coming due every year. If rates go higher, you can reinvest next year at a higher rate. And if rates go lower, you have locked in a good rate for 10 years.

I have no idea when rates are going to go higher, or when the next earthquake will be, who will win the lottery, etc. And neither does Bill Gross, Ben Bernanke, or Alex Trebek.

Build a laddered bond portfolio and take the guesswork out of predicting where interest rates will go. And take 2 Tylenol, and call me in the morning.

Disclaimer: when you create a laddered bond portfolio, you still can lose money. Interest rates can go up, bond prices can go down, and whoever you lend to could go out of business. This strategy isn’t for everyone. This is not to be construed as individual investment advice. Consult your financial advisor for more details.