By Jonathan Burton, MarketWatch
SAN FRANCISCO (MarketWatch) -- One of bonds' big bugaboos -- reinvestment risk -- is reappearing, and bond holders accustomed to attractive short-term yields are due for a rude awakening.
Reinvestment risk kicks in when bonds, bank certificates of deposit and other fixed-income holdings mature and investors are forced to buy new issues at lower yields. This hasn't been a problem for several years; the Federal Reserve hiked short-term interest rates successively from June 2004 until June 2006 and kept the rudder steady until Tuesday. In that climate, it paid to keep bond and CD maturities short, reinvesting principal at higher rates when paper came due.
Not any more. "Reinvestment risk is back on the table," said Marilyn Cohen, president of Envision Capital Management, a Los Angeles-based investment firm specializing in bonds. "The CDs that were generous in their yield are probably going to become less so."
Indeed, the Fed's half-point cut in short-term borrowing rates on Tuesday underscored what the bond market had been signaling for months: the economy is sputtering and short-term yields are declining, meaning less for income-hungry investors. Two-year Treasurys, for instance, yielded about 4% on Thursday; investors could have locked up 5%-plus in mid-June.
Sharper curves ahead
What can income-oriented investors do to counter reinvestment risk? Climb a ladder.
Specifically, consider a strategy called "laddering." Buy bonds with staggered maturity dates and hold them. When a bond matures, reinvest the proceeds in a new bond with a maturity date at the top rung of the ladder.
In this way, you're continuously exposed to prevailing yields on bonds within a targeted range. The strategy applies to all bonds: U.S. government issues, city and state municipal bonds and corporate debt. It's also effective for CDs. But in this changing environment, investment advisers are divided about a ladder's optimal length.
Cohen says investors could build a 12-year ladder that favors longer-dated U.S. government bonds and keeps 15%-20% of a bond portfolio in short maturities of one to three years.
Muni-bond investors should start the ladder with five-year bonds, she says, and extend maturities to 2020. Cohen adds she's avoiding corporate bonds: "I am worried about the lack of liquidity."
Jason Brady, manager of Thornburg's Limited Term Income /zigman2/quotes/204152813/realtime THIFX +0.07% and Limited Term U.S. Government /zigman2/quotes/208132364/realtime LTUSX -0.07% funds, says laddering can turn reinvestment risk into an asset, since it banks higher long-bond yields while short-term issues reduce volatility.
"The ladder effectively constructs a portfolio which has less exposure to interest-rate movement," he said.
In contrast, Mark Balasa, an investment adviser in Itasca, Ill., suggests a much shorter ladder of between one and four years, divided equally. "That way you're not making an (interest-rate) bet," he said.
Importantly, holders of some longer-dated muni and corporate bonds should understand that reinvestment risk can be forced upon them. Such "callable" bonds can be retired prior to maturity. They sport higher yields to sweeten the pot, but a declining-rate environment gives issuers good reason to repay debt and issue new bonds at cheaper cost.
Noncallable bonds do exist, but are difficult to find. At the least, both corporate- and government-bond holders should look for a couple of years of call protection, Cohen says.
Funds for bond ladders
Laddering U.S. government bonds is simple if you buy from the Treasury directly. Account set-up and other information are available at the agency's Web site, www.treasurydirect.gov .
Most people rely on mutual funds or exchange-traded funds for bond investing. Find the least expensive offerings; being miserly about fund costs is important generally, but crucial given bonds' typical single-digit returns. Here are some choices:
Short-term: Consider Fidelity Ultra-Short Bond Fund , which recently had an average duration, or sensitivity to interest rate changes, of about five months. Also, Pimco Low Duration Fund /zigman2/quotes/200986696/realtime PTLAX 0.00% , which recently sported a portfolio with a three-year duration, Vanguard Short-Term Bond Index /zigman2/quotes/209979755/realtime VBISX -0.09% , had a duration of about 2.4 years, while Vanguard Short-Term Federal Fund /zigman2/quotes/209343727/realtime VSGBX 0.00% , a government-bond fund, had a duration of 2.2 years. Fidelity's offering is an "Analyst Pick" of investment researcher Morningstar Inc.
ETFs have even lower expenses than many traditional funds, though you'll pay trading costs. Ultrashort and short-term bond ETFs to consider include iShares Lehman Short Treasury Bond /zigman2/quotes/204686525/composite SHV -0.0090% , with an average duration of under five months, iShares Lehman 1-3 Year Treasury Bond /zigman2/quotes/204549300/composite SHY -0.08% , iShares Lehman 1-3 Year Credit Bond , and Vanguard Short-Term Bond ETF /zigman2/quotes/208505980/composite BSV -0.05% .
Intermediate-term: Check out these Morningstar favorites: Harbor Bond Fund /zigman2/quotes/209506950/realtime HABDX 0.00% , which famed bond investor Bill Gross runs at a lower cost than his flagship Pimco Total Return Fund /zigman2/quotes/210424051/realtime PTTAX -0.19% , and Dodge & Cox Income Fund /zigman2/quotes/205671106/realtime DODIX +0.21% , with an average duration of just under four years.
Among ETFs, options include iShares Lehman 3-7 Year Treasury Bond /zigman2/quotes/204694834/composite IEI -0.24% , Vanguard Intermediate-Term Bond ETF /zigman2/quotes/206352493/composite BIV -0.36% and iShares Lehman 7-10 Year Treasury /zigman2/quotes/202862654/composite IEF -0.59% .
Long-term: Vanguard Long-Term U.S. Treasury Fund /zigman2/quotes/201786083/realtime VUSTX -1.29% has an average duration of about 10 years and rock-bottom expenses. It's Morningstar's top choice among long-term government-bond funds.
A diverse lineup, for example, might be split evenly between iShares Lehman Short Treasury Bond, Vanguard Short-Term Federal Fund, Harbor Bond Fund and iShares Lehman 10-20 Year Treasury Bond. Keep in mind that bond funds, unlike individual bonds, don't have maturity dates, and a laddered strategy using funds won't be as precise.
Finally, remember that while it may be a new climate for bond investors, one time-honored rule still applies: Don't fight the Fed.
"Laddering gives me the best of both worlds," said John Nersesian, a managing director at Chicago-based Nuveen Investments. "If rates go higher, shorter-term maturities come due and allow me to reinvest at higher interest rates. It also protects me when rates head lower, because at least I have some money committed to longer-dated maturities."