In part 3 of my asset allocation series, I explained why adding bonds to your portfolio can help reduce your portfolio’s overall risk. But bonds are not risk-free (including supposedly “risk free” U.S. Government Treasuries), and interest rates are the prime culprit.

Bonds Have Interest-Rate Risk

Even if a bond doesn’t default (i.e., credit risk), you’re still not out of the woods. Another type of risk remains: interest-rate risk. There are two main types of interest rate risk: (1) reinvestment risk, which occurs if interest rates fall; and (2) principal risk, which occurs if they rise. Take, for example, a new-issue 10-year U.S. Treasury note that sports a yield to maturity (YTM) of 2.95%. The holder receives an interest payment every six months, and the YTM assumes that money can be reinvested at the same rate. But in reality, the money can only be reinvested at the current interest rate, which could be lower. Thus, the possibility that interest rates will fall in the future creates reinvestment risk.

Principal risk occurs if interest rates rise in the future. The price of a bond moves in the opposite direction of interest rates. If interest rates rise, the bond price declines. This is only a problem if you need to sell your bond prior to its maturity, because at maturity, you are guaranteed a return of your investment principal (assuming you bought a new-issue bond where your investment cost equals the par value of the bond). But unforeseen cash needs do occur, and you may need to sell your bonds prior to maturity. If you have to sell, rising interest rates will cost you.

Bonds Offer Higher Yields

Given these risks, you may be wondering why you should bother with bonds at all; why not just keep cash in ultra-safe money-market funds? The short answer is that you will be forfeiting yield. The vast majority of the time, the yield curve — the relationship between interest rates and time to maturity — is upward-sloping, meaning that the interest rate you receive increases the longer you are willing to lend the money.

This makes sense because the destructive power of inflation compounds over time, and investors consequently demand higher interest rates to compensate for greater inflation risk. Higher inflation does not always materialize, though, so investors who are willing to lend money for a longer term are sometimes amply rewarded.

Ah, but that darn interest rate risk. But I’ve got good news: There’s a way to combat it: bond ladders.

Bond Ladder to the Rescue!

Fortunately, there is a way to reap the reward of longer-term debt investing (i.e., higher yields) without incurring all of the interest rate risk inherent to bond investing: bond ladders.

As with stock investing, the key to successful bond investing is risk reduction through diversification. A bond ladder is nothing more than a diversified portfolio of bonds with different maturity dates. Each “rung” of the ladder is a bond of a specific maturity date and the “height” of the ladder is the difference between the shortest maturity bond and the longest maturity bond. The more rungs in your ladder (10 or more is best), the better the diversification, the more stable your yield, and the higher your average yield.

To illustrate, I’ve set up a hypothetical 10-rung bond ladder, assuming an upward-sloping yield curve:

Staving off Reinvestment Risk

Each year, one rung of the bond ladder matures, returning your principal at par value ($1,000), and the remaining rungs each move down one year in maturity, so the 2012 bond becomes a one-year maturity, the 2013 bond becomes a two-year maturity, and so on. To keep the ladder going, you must reinvest the proceeds from the matured rung into a new 10-year bond. This way, new money is constantly being reinvested at the higher, 10-year bond rate. If interest rates have risen, you get to reinvest at higher rates. If they’ve fallen, the ladder structure minimizes reinvestment risk because only a small portion of your total investment matures at any given time.

Fighting Principal Risk

But wait, there’s more: As your longer-term bonds get closer to maturity, their price — the amount you’d get if you decided to sell them on the open market — increases to reflect the lower interest rate of shorter-term debt (thanks to the upward-sloping yield curve). This price increase adds value (i.e., extra yield) to your ladder on top of the high coupon (i.e., interest) payment, which remains the same throughout the life of the bond.

For example, look at the price of the 10-year bond (i.e., the one that matures in 2020) under the constant interest rate scenario. After six years of maturing, its annual coupon payment will still be $29.50 even though the interest rate for a four-year bond implies an annual coupon of only $12.00. This causes the bond to rise $4 in price from the original cost of $1,000, which adds about 0.4% in value to the original 2.95% yield, producing an effective yield of 3.35%.

Surfing the Roll, Baby!

This added value is called “surfing the roll” down the yield curve. Keep in mind that even though the bond price falls back to $1,000 at maturity, the bond pays out its original 10-year coupon amount of $29.50 all the way to the bottom rung.

By the time your initial 10-year bond has matured, every rung of your bond ladder is paying interest at the 10-year rate level. Consequently, your entire bond ladder is generating long-term 10-year yields, yet principal risk is much less than that of a single 10-year bond because the ladder’s bottom rungs are maturing every year, returning your principal. The best of both worlds!

As Thornburg Investments put it in a recent article:

It really doesn’t matter which way interest rates move. With a laddering strategy, it’s possible to get consistent returns. This gives laddering investors a competitive advantage, knowing any time is a good time to build or buy into a laddering portfolio. It’s the smart way to increase a portfolio’s return while minimizing both market and reinvestment risk.

Bond ladders have proved their worth over the test of time. According to Ed Easterling, author of Unexpected Returns, the total return of “seasoned” bond ladders with lengths of 10 years or less have been positive each year over the past 100 years! Given such a strong performance record, that is one ladder I am definitely willing to climb.

Note: The benefits described above exist only if the bond ladder comprises non-callable bonds and only if the yield curve is upward-sloping (which it is most of the time and certainly is today). For simplicity, I have called all debt securities “bonds,” even though the formal definition of a bond is a debt instrument that matures in greater than 10 years.