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08/03/2014 03:59 EDT | Updated 10/03/2014 05:59 EDT

Throw Away Your Bond Ladder

The first step is to devote just enough funds in short-term vehicles or ones that mature when you need specific payments. Pension funds have been using the strategy of liability matching, for generations where they meet liability payments with specific investments coming due at that same time.

Bond ladders were the fool-safe recommendation dispensed by almost everyone over the last 35-year bond rally. The idea was simple. Invest in bonds or GICs with staggered maturity dates. As each one comes due, reinvest the funds into a new bond with a longer maturity date than the longest term held in the portfolio. By doing this, you can extract the highest interest rates available, since normally, longer terms pay better yields than shorter ones. You can therefore take advantage of the highest interest rates available by locking up this small portion of the portfolio, knowing that another bond is coming due in the next year or so.

You maintain a continuous string of cash flow to spend or reinvest, which provides stability over volatile interest rate markets. Rather than having most of your money come due at the same time and needing to reinvest it all at once, entering into new investments at regularly spaced intervals creates an averaging effect. Also, the consistent string of maturity dates give you access to your money when you need it, for lifestyle expenses or other more interesting adventures.

For investors who want to profit from changes in bond prices, a bond ladder shortens the sensitivity to interest changes, since your average term to maturity (and duration) is shorter than the longest bond that you own. That lowers the overall volatility in your portfolio. Most investors however, don't actively trade bonds. Rather, they opt to hold them to maturity, rendering the ongoing changes in the interest rates inconsequential, deeming bond ladders a brilliant strategy during a high and falling interest rate market (falling interest means rising bond prices). It's conditions like these that make earning money in the bond market as tricky as flying a kite on a windy day.

Today, interest rates are near zero. As interest rates rise, bond prices fall. Moreover, current coupon interest payments are paltry. Once you factor in the slice you send to Ottawa and the rising price of goods and services that we all pay for, you're as well off as any mattress-stuffer across the provinces and territories. Investing in bonds is a hazardous venture that isn't priced to compensate us for the risks we are taking on. Guaranteed loss of purchasing power isn't a fair game, whether you stagger maturity dates or not. And if we don't want to hold these bonds to maturity, the risk of losing capital as interest rates rise, isn't fair either for the ultra-conservative investors who have relied on these vehicles for decades.

So, what's the alternative? You need safety but what else can mitigate these risks? Solving this problem is easier than you think, even for wary investors.

The first step is to devote just enough funds in short-term vehicles or ones that mature when you need specific payments. Pension funds have been using the strategy of liability matching, for generations where they meet liability payments with specific investments coming due at that same time. By having safe money available as needed, a wider range of options are at your disposal for your remaining money, including much longer-term strategies than what you may have considered otherwise. Since your immediate cash flow needs are already met, you create liberty to be patient with other investments, even those replete with the volatility of a market cycle. Investing in good quality equities, for example, can enhance your overall strategy by providing capital appreciation, which in turn, can maintain or increase your purchasing power over long periods.

As an economy expands and the cost of goods and services rise, stock prices concurrently increase in value, all else being equal. Since you have removed the risk of having to withdraw funds when capital markets are down, you may be in a position to withstand some volatility in your portfolio, making equities a more tolerable option in a conservative portfolio.

Moreover, good quality equities provide the possibility of a return in excess of the interest payments promised on current bonds. And as a bonus, taxes paid on capital gains and eligible dividends from Canadian corporations are taxed more favourably than interest payments.

Every strategy has its day. Nothing lasts forever in a dynamic environment, including formerly, well-regarded investment strategies.

This information should not be construed as investment advice, nor can it take into account your own specific circumstances. The opinions formulated within this article are based on sources believed to be reliable and may not reflect the opinions of any organizations that I am affiliated with.

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