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A Bond Fund Alternative

Bonds have always had a place in a diversified portfolio. But for those concerned about interest rates---and who want to be positioned to take advantage of rising rates when they eventually start inching upwards---there's another choice: Laddering.

One of the simplest investment strategies around involves buying a handful of fixed-income securities---each with a different maturity date--and staggering those maturity dates so that each year or so, you'll have money coming due to reinvest all over again.

The pros refer to this technique as building a laddered portfolio and it can be done with taxable or tax-free bonds, corporate, Treasury , or even certificates of deposits.

Along with having a steady income stream and money to reinvest regularly, one of the primary benefits of laddering is that it allows you to capture movements in a changing interest rate environment. For instance, with $5000 to invest today, you could make a five-year laddered portfolio of securities by purchasing a $1000 bond or CD that matures in one year; another maturing in two years; another that matures in three years; and so on until the $5000 is spent. Each fixed-income security will have a different yield or interest rate on it---the shortest maturing one the lowest, the longer maturing, the highest.

Then next year, when the one-year bond or CD matures, you'll reinvest that $1000 by purchasing a bond or CD that matures in five years. That move allows you to take advantage of what the new 5-year rates on fixed-income securities are. If rates have moved upward, that new investment will add some yield spice to the overall laddered portfolio.

Why reinvest in a five-year maturing bond? For two reasons: First, in this example, five years is the longest holding period. And second, because the one-year bond that has matured brings the original two-year maturing bond down a rung. That leaves the 5-year maturity rung open.

But, a five-year ladder isn't the only way to go---you can stretch maturities out to say eight or 10 years and stagger maturity dates ever couple of years as well. One word of caution, the longer the maturity date on a bond, the riskier it's considered. So, take a clue from the pros and be careful not to extend the maturity dates on your laddered portfolio of securities out too far.

This strategy is a good way to build a rainy day fund or provide income. So, just as bond funds can be sound investments, a laddered portfolio made up of high-quality fixed-income securities can be easy to manage, inexpensive to maintain and worth investigating.

Equity funds and getting even...

Lipper numbers show that money has been moving back into stock funds lately thanks to market rallies here and there and investor optimism as many of our troops have returned home from Iraq.

In April, for instance, stock funds saw inflows of $14 billion dollars---the largest since April 2002.

As for equity fund performance, as of May 15, the average US domestic stock fund's total return was over 8.2 percent and the average sector fund's year-to-date total return up over 12 percent. If this trend continues, bought-and-held equity fund investors could start to see some of their fund holdings begin to grow in value rather than decline. And that's the good news. The bad news is, getting even takes time.

In the past, this column has reminded investors that an investment has to grow 100 percent if it had lost 50 percent. Now, let's look at the math for smaller amounts.

According to PMFM, Inc. a money management firm in Athens,GA,, if your investments are down 10 percent, you'll need a gain of 11.11 percent to break even; a loss of 15 percent, means your investments will have to grow by 17.65 percent; and if you're down 20 percent, it will take an increase of 25 percent to get back to even.

"Buy and hold investors spend a disproportionate amount of their time just trying to get back to even, " says Judson P. Doherty, a CFA at PMFM.

Doherty explained that someone who invested $10,000 in the S & P 500 index at the beginning of 1996 would have seen that investment grow to $25,000 at year-end 1999. Over the next three years, however, that investment would have declined to $16,000. "Simply to get back to their pre-bear market value, they'll need to average 10 percent per year for five years. In the end, they will have spent one-third of the time actually making money and two-thirds fighting to get back to even."


Dian Vujovich is a nationally syndicated mutual fund columnist, author of a number of books including Straight Talk About Mutual Funds (McGraw-Hill), and publisher of this web site.

To read more articles, please visit the column archive.

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