Understanding and Reducing Interest Rate Risk

I'm sure that everyone reading article is familiar with interest rate risk in one form or another. For example, when you take out a mortgage to buy a house, you might wonder what term to select. People have two primary concerns: being locked in at a high interest rate after interest rates have dropped, or conversely, if they'll be able to afford the payments if interest rates go up. Bonds and Certificates of Deposit (CDs) pose similar quandaries. If we invest in a bond or CD at five percent and rates subsequently increase to seven percent, we've left some serious money on the table. If you were to ask pension managers what they think of that scenario, most will tell you that it's no different than losing money. If we buy a long-term bond or CD and rates go up, we lose money. If we play it safe and rates stay the same or drop, we lose money as well (because we'll be forced to reinvest at a lower rate later).

I like to refer to this phenomenon as the interest rate game. Most of us have played at one time or another. When you play the interest rate game, you're taking a completely unnecessary risk. Remember, our overall goal is to get the maximum return for the minimum possible risk. Pension fund managers know that if they play unnecessary games, eventually they'll lose. You should know this too.

There's some type of risk involved with all investments; our task here is to neutralize that risk. How do we do it with this risk type? We build a ladder and climb over interest rate risk.

A bond ladder eliminates much of interest rate risk by breaking up your investment portfolio into roughly equal chunks of money, invested for different periods of time. A large investment portfolio might have thirty such chunks, with each piece forming a rung on a one- to thirty-year bond ladder. Laddering is a common strategy among the great pension plan managers, because it completely eliminates interest rate risk.