June 2002 Bulletin

Building profitable bond portfolio

Laddering strategy helps manage risks

By Joel M. Blau, CFP

Many investors, understandably concerned about the future of the equity markets, are looking at alternative investment vehicles. For physicians who desire added diversification in the hope of reducing the downside risk within their portfolio, fixed income securities (bonds) may be the answer.

Unlike equities (stocks), which represent ownership of a corporation, bonds represent the debt of a corporation or municipality, with bondholders playing the role of a bank. Money is loaned to the entity in return for a promise of a stated interest rate and the repayment of the loan on a specified date. If the entity is a corporation, interest payments are received on a taxable basis, while municipal bonds generate federally tax-exempt income. Certain other bonds, known as zero coupon bonds, do not pay any current income, but rather are purchased at a discounted price and mature at a predetermined value at a specified time.

As opposed to equities, where stock prices are determined by factors such as anticipated earnings, market share, and expectations of future profitability drive that price, bond pricing is impacted primarily by the current interest rate environment. Quite simply, bond prices move inversely with interest rates. As interest rates increase, bond values go down. Likewise, if interest rates decline, bond values tend to increase.

Managing risk

The difficulty with adding bonds to a portfolio in order to reduce overall inherent risk is the possibility that you’ll lose principal within the bond portfolio if interest rates increase, thus defeating the objective of risk reduction. Hence, the question becomes, how do fixed income investors achieve a respectable rate of return without experiencing the higher risk associated with interest rate fluctuation? What is the adequate offset of higher risk for higher return?

In an effort to minimize the impact of interest rate changes, investors may wish to diversify their bond portfolios based on varying maturities. The shorter the maturity of the bond, the less sensitivity it has to changing interest rates, but it also typically pays a lower interest rate. The key lies in structuring a bond portfolio that generates higher current income, but with greater downside protection than simply purchasing longer-term bonds.

Bond laddering

A reasonable strategy may be "bond laddering". Laddering involves building a portfolio of bonds with staggered maturities so that a portion of the portfolio will mature each year, or some other specified time period. Laddering can be accomplished by purchasing individual bonds or bond mutual funds, since the mutual funds may invest in bonds with varying maturities, or within a specific time frame, such as short term, intermediate term, or long term. By spreading out the maturities, you are investing at different interest rates, with the shorter-term bonds paying a lower rate compared to the longer-term bonds. At the same time, you are spreading out the risk of principal fluctuation.

The practice of laddering a bond portfolio provides a very attractive method of diversification. If current income is not an objective, bond mutual funds offer the advantage of income reinvestment, allowing you to purchase additional bonds at current price levels.

Joel Blau, CFP, is president of MEDIQUS Asset Advisors, Inc. He may be reached at (312) 419-3733 or by e-mail at blau@mediqus.com.

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