As the Reserve Bank of India has increased the repo rate by 225 basis points since May this year and the yield to maturity across various debt fund categories is offering attractive opportunities, individual investors should look at bond laddering, consisting of paper of different maturity dates at regular intervals. Such a strategy will not only create a regular flow of money for investors but will also minimise the risk associated with future movements in interest rates.
Bond laddering will help smooth out the effect of interest rate fluctuations and spreading out maturity dates every month, quarter or year will prevent retail investors from timing the market. It will also help to mitigate the reinvestment risks in case the interest rates fall. In such a case, while some bonds maturing will have to reinvested at lower rates, those which are at the end of the ladder will not be affected as they would be already locked in at higher yields.
Also Read: Fixed Income: Target maturity funds a good bet
Investors can adopt the same laddering strategy for certificates of deposit or even bank fixed deposits. With some banks offering over 8% for special tenor deposits, one can make the most of this situation by laddering their fixed deposits. However, avoid locking-in for longer durations because there is still headroom for the rates to rise.
How to go about it
A bond portfolio using laddering would consist of paper having the same face value maturing on different dates at regular intervals. Look at the spacing between maturities of the bonds and the types of securities you would like to invest. Also factor in the amount of money to be invested and the number or rungs to spread the amount. The spacing of the ladder should be decided based on one’s cash flow needs and the time of maturity of the various bonds. Building ladders with more bonds require significant investments but provide a higher maturity range.
Brijesh Damodaran, managing partner, BellWeather Associates, says to maximise the gains from laddering, one must invest in high-quality bonds that are ‘AAA’ ratings. Remain invested until maturity because the interest rate risk will rise, and the income will fall if you withdraw the money prematurely.
Look at target maturity funds for laddering
Target maturity funds are an effective way to build bond ladders because the duration of these funds reduces over time and are less prone to price volatility due to interest rate changes. Through these funds, individuals can build the ladder by investing in different types of debt and money market securities such as commercial papers, certificates of deposits, non-convertible debentures and State Development Loans. These passive debt funds align their portfolios with the maturity date of the fund and track an underlying bond index.
Also Read: Fixed Income: Go for low duration funds now
The volatility tends to reduce as the fund gets closer to the target maturity and investors who are targeting specific segments of the yield curve are able to invest in these funds without being locked in till maturity. Individuals should invest money in target maturity schemes that mature in three to four years from now and then invest in longer duration when the interest rates peak out, points out Damodaran.
UP THE RUNGS
A bond portfolio using laddering would consist of paper having the same face value maturing on different dates at a regular interval
Target maturity funds are an effective way to build bond ladders because the duration of these funds reduces over time and are less prone to price volatility due to interest rate changes