A major challenge for most income orientated investors is finding a way to increase their overall returns in fixed income areas. This is because interest rates are at the lowest levels in decades (which makes it difficult to see higher levels of income). Once inflation is calculated into these figures the position could be taking a loss. To deal with these challenges most investors will seek out areas that are paying higher amounts of interest. The problem is that this could increase the overall risks to the portfolio exponentially by purchasing bonds with lower credit ratings. To avoid these kinds of issues, most investors need to use certain strategies that will increase the overall return without the risk.
The Use of Laddering
The best way to improve the overall return for the portfolio is through a technique called laddering. This is when investors will take the fixed income securities in the portfolio and will spread them out over the range of maturities. For example, if an investor wanted to see higher rates of interest in CDs. They will concentrate on spreading out this portion of the portfolio over the course of several months to years. This means that they will have a mixture of shorter and long term CDs (ranging from three months to 15 years). The basic idea is that the short term instruments will provide income and will mature at certain points. This allows them to invest in new CD offerings when interest rates are rising. While the long term CDs, will provide the portfolio with higher amounts of interest.
Advantages of Laddering
The biggest advantage of laddering is that the interest rates in the portfolio will continue to remain high. When they are increasing, the shorter maturities that are coming due will provide investors with the chance to capitalize on this opportunity. Over the course of time, this causes the average interest rate to remain consistently high (without increasing the risk).
During times when interest rates are falling, investors can place the amounts that are maturing into medium term instruments. This is designed to prevent the portfolio from being adversely impacted by sharp declines. Once this takes place, is when investors are able to maintain higher yields in comparison with the markets.
A second advantage of this approach is that it always protects against inflation. The main reason is due to the fact that the highest rates are continually being locked in. At the same time, the investments that are maturing can ensure the portfolio takes advantages of potential increases. The combination of these factors will keep the average yield higher.
Clearly, prudent investors will use tactics such as laddering as a way to structure their fixed income securities. This is because it is providing them with a number of advantages that other strategies are unable to achieve (higher interest rates with lower risks). Together, these tools will protect the portfolio against inflation and sharp decreases. This is when there will be more consistent income levels regardless of what is happening.