We don’t want to get too tricky (because we really do believe in keeping bonds as simple as possible), but there is one strategy, called laddering, that can help stabilize the bond portion of your portfolio—much as dollar-cost averaging helps even out the price fluctuations in your stock portfolio. Here’s how it works: Instead of buying bonds that are all scheduled to come due in the same year, when you ladder you buy bonds scheduled to mature at evenly spaced future dates. The idea is that if the rates go up, you can renew your maturing bonds at the better, higher rate. But if the rates go down, then you’ll still have your other bonds locked into higher rates.
For example, say you invest $60,000 equally among three bonds that mature in one to three years. Bond A yields 5%, bond B yields 5.25%, and bond C yields 5.5%. In the first year your portfolio will generate an average return of $3,150 (5.25%) from the three bonds.
In a year bond A matures, and you invest the proceeds in bond D, which matures in three years. If interest rates have gone up, let’s say to 6%, your new portfolio will generate a return of $3,350 (5.58%).
But if interest rates have fallen, you still buy the new bond at the lower rate. Although your yield will be lower for this bond, you will have the peace of mind of knowing that you locked in a higher rate for your other bonds. In other words, you’re in good shape regardless. If interest rates go down, you’ve locked in a higher rate. If interest rates go up, you can continue to buy bonds that pay higher yields.