Add stability to your fixed income portfolio with a laddering strategy!

Interest rate risk is one of the major risks while investing in fixed income. Want to reduce it? Read on to find out more.

Fixed income is often viewed as one of the safe investment avenues. Despite this, it does carry its own set of risks namely interest rate risk, reinvestment risk, credit risk, etc. Therefore, it is important to understand that though they are considered safe they are not completely risk-free. However, there are various strategies to reduce these risks. In this article, we would be dealing with a laddering strategy that helps you reduce interest rate risk.  

So, to begin with, let’s understand what is laddering strategy?  

A bond laddering strategy is where you build a portfolio of fixed income securities with different maturity dates. For instance, a portfolio build using this strategy might have securities that are maturing in one year, three years, five years, seven years and 10 years. The chief intention of the laddering strategy is to protect investors from interest rate risks. We will be understanding the benefits of the laddering strategy and how you can build one.  

However, before we move ahead, let us know the interest rate risk and how the bond laddering strategy can help you reduce the same.  

Interest rates are inversely proportional to bond value. This means that any rise in interest rate would lead bond prices to move southwards and vice versa. Therefore, this is one of the most important risks that one needs to consider while investing in fixed income.  

Bonds of varied maturities have different price sensitivities to interest rate changes. Interest rate sensitivity, which is also known as the duration of a bond is directly related to the bond maturity. The longer the maturity of a bond, the higher is its sensitivity to interest rate changes. You might have come across the term Macaulay duration or modified duration in mutual fund factsheets or on mutual fund research websites.  

So, how to manage interest risk with a bond laddering strategy?  

Let’s say, you have Rs one lakh to invest in fixed income. If you invest the entire amount in bonds or debt mutual funds having shorter maturities, your interest rate risk will be lower. However, the yields will also be lower which in turn result in lower returns.  

On the other hand, investing the entire amount in bonds or debt mutual funds having longer maturities, your yields will be higher which in turn would improve your returns. But in that case, your interest rate risk will also be higher. It is quite critical for you as an investor to know this risk-return trade-off.  

Therefore, to manage this risk-return trade-off, you need to invest equal amounts in bonds having different maturities. As and when shorter-term bonds mature, invest the maturity proceeds in the longer maturity bonds.   

Now say, if the interest rates surge, you will benefit from higher yields for your re-invested maturity proceeds in longer maturity bonds. On the contrary, if the interest rates fall, you will be re-investing in lower yields than before. Having said that, the bonds at the end of the ladder will have locked in higher yields already providing stability to your income from the bond portfolio. The advantage of the bond laddering strategy is that it works in both rising and falling interest rate scenarios.    

How you can practically implement the bond laddering strategy? 

You can very well implement this strategy with the help of target maturity Exchange Traded Funds (ETF). At present we have around eight target maturity ETFs spread around seven different maturities ranging from the year 2023 to 2031. So, you can create a laddering strategy by investing equally in ETFs maturing in April 2023 (close to one year), April 2025 (close to three years), April 2030 (close to eight years) and April 2032 (close to 10 years).  

Here is the list of target maturity ETFs.