Yesterday I asked readers Do You Know this about Vanguard Wellington and Wellesley Funds? I explained that we have not soured on the funds, but that their effective maturities are longer than we’d like. I also wrote that at Young Research we recommend laddering bonds.
One of the reasons we favor laddering bonds is to help strip-out interest rate risk. When you own a bond outright you have control over your holding period.
Duration measures a bond’s sensitivity to interest rates. For example, a bond with a 15-year duration will decline by 15 percent with every one percent increase in interest rates. Would you pay the same price for a bond you bought last year that yields one percent more today? No, you’d pay less—about 15 percent less in this case.
Compared to a three-year duration—it will decline by about three percent if rates increase by one percent—you’d lose a lot less. And if you happen to own the bond in a ladder you could hold it, collect your interest along the way, and receive your principle at maturity.