With yields of 0.15% on T-bills and 2.6% on five-year CDs, the temptation of many investors is to reach for yield. Don’t do it. When you reach for yield, you are either taking on too much credit risk or too much maturity risk. With a flood of government debt issuance in the pipeline, and a bloated Federal Reserve balance sheet, much higher interest rates are a dangerous prospect. Don’t forget that a seemingly modest 1% rise in interest rates could decimate a long-bond portfolio. I’m talking about losses upwards of 20%. That’s not what most bond investors sign up for.
Instead of reaching for yield and risking significant principal loss, you want to craft a short-term bond ladder. You’ll have to suck up low short-term rates for a time, but when interest rates rise you’ll be sitting in the catbird’s seat. You’ll invest the proceeds of your maturing low-yield, short-term bonds in higher-yielding, longer-term bonds. As a result, the yield on your portfolio will rise with interest rates, and you’ll avoid the portfolio-decimating losses that the yield-reachers are likely to endure.
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