Bonds course · Lesson 6 of 7
A ladder and a fund lose the same value when rates rise.
Many investors build a ladder of bonds so that they never see a loss. The loss is still there. A ladder only changes how you see it.
The ladder
The example ladder has 10 bonds of $10,000. One matures each year, from 1 to 10 years. Each pays a 4% coupon, and each sells at face value. The total is $100,000.
Rates rise 1 point
At once, the market value of the ladder falls to $95,396.70, a loss of 4.60%. A bond fund that holds the same bonds loses the same amount. The ladder owner does not see the loss on a statement, but the bonds are worth less.
The ladder owner can hold each bond to maturity and get its face value. But the money then earns 4% in a market that pays 5%. That is the same loss, paid slowly.
The higher rate pays it back
| Year | Value, no rise | Value after the rise | Difference |
|---|---|---|---|
| 0 | $100,000 | $95,397 | -$4,603 |
| 1 | $104,040 | $100,226 | -$3,814 |
| 2 | $108,243 | $105,300 | -$2,943 |
| 3 | $112,616 | $110,631 | -$1,985 |
| 4 | $117,166 | $116,232 | -$934 |
| 5 | $121,899 | $122,116 | $216 |
| 6 | $126,824 | $128,298 | $1,474 |
| 8 | $137,279 | $141,617 | $4,338 |
| 10 | $148,595 | $156,319 | $7,724 |
After the rise, each coupon and each bond that matures earns the higher rate. So the value grows faster. After about 4.8 years, the owner is ahead of the path with no rise. That is close to the Macaulay duration of the ladder, 4.86 years.
This is true for the ladder and for the fund. A rate rise hurts first and helps later, and the duration tells you when the help arrives.
When a ladder helps
A ladder helps when you need a known amount of cash on a known date, such as tuition or the first years of retirement. A fund helps when you want low cost, many issuers and no work.
Key points
- A rate rise lowers the value of a ladder and a fund by the same amount.
- Higher rates pay back the loss over time, in about the duration.
- Choose a ladder for dates that you know, and a fund for ease and diversification.