INSIDE FINANCE
"Climbing Up the Ladder"

By Robert M. Jaffe, MBA, AAMS
June 24, 2005

In my last article, C.I. June 10, I touched on interest rates and how they might affect the surge in housing construction, prices and speculation. Those prices, and the mountains of leverage in our system, can't continue to grow forever. At this writing, long-term (10 year) rates hover just above 4 percent, and short-term (2 year). Currently we are in a period of rising rates and falling bond prices.

So, what does this flattening yield curve mean to you and me? "Bonds 101" is pretty simple. Investing in longer term bonds isn't worth the additional risk, because there is hardly an additional payoff. If you own a fixed interest instrument (bond) with a coupon of "x" percent, and a new bond is issued with a higher yield, then your bond will be worth less (that's not worthless, just not as valuable). After all, why should someone purchase your bond with a lower rate of return? Of course this goes on daily and always has.

Most bond-market investors have been cautious for the better part of more than two years, fearful that rising market yields would reduce bond prices.

It is interesting to note that investors have historically tended to buy into bond funds at precisely the wrong time, that is, when interest rates have bottomed and begin to rise. Compounding matters, they also sell at the wrong time, when interest rates peak and then begin to decline. Driven by emotion, bond fund investors, and for that matter, stock buyers as well, have tended to buy high and sell low, over the last fifteen years.

In my opinion, and that of many bond fund managers whom I respect, bonds should be bought when prices decline, yields are higher, and the potential for appreciation is greater. So, how then can you do this efficiently? One way to "beat the system" would be to create a laddered bond portfolio. Three primary risks inherent in fixed income investing that can be tempered by a laddered portfolio are credit risk, market risk and reinvestment risk. Depending upon your level of expertise and your pocketbook, you can purchase individual bonds OR you can put your money in the hands of a professional bond fund manager. My personal recommendation would be to choose a laddered bond fund.

In simplest terms a laddered portfolio is made up of bonds maturing on different dates. For example, assume there are ten bonds in the portfolio and each matures successively one year after the other. When the first bond matures it is replaced with one that will mature in ten years, and so on. What this accomplishes is two-fold. As the bonds age, the principal from the maturing short-term bonds is used to purchase new longer-term bonds, thus softening interest rate risk as well as market price risk. In an environment of rising interest rates, principal values decline but the investments in new less expensive bonds with higher yields at the long end ultimately increase the overall yield of the portfolio. Conversely, if interest rates are declining then the price of the bonds at the long end will be greater, thus increasing the principal value of the portfolio.

If bonds are part of your investment strategy this may be one way to climb the ladder of success.

Please Email bob@cfsias.com with your questions.

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INSIDE FINANCE will appear regularly, addressing financial matters of interest to our readers. Any questions? Email bob@cfsias.com

Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member NASD/SIPC. Cambridge and CFS are not affiliated.

The preceding article is for informational purposes only and should not be used as the primary basis for an investment decision. Indices mentioned are unmanaged and cannot be invested into directly. Past performance does not guarantee future results. All examples given are hypothetical and do not reflect actual investments. The views expressed in this article are those of the author and are not necessarily those of Cambridge. Bob Jaffe is Managing Director of CFS Investment Advisory Services, LLC in Totowa and has been a Clifton resident since 1984. Active in community affairs, Bob is Past Board Chairman of the North Jersey Regional Chamber of Commerce and a member of its foundation board. He serves as a commissioner on the Clifton Rent Leveling Board and the Committee for Individuals with Disabilities. He is Vice President of the Clifton Rotary Club. Representatives of Cambridge do not offer tax or legal advice. Consult a professional for your personal situation.