In part 3 of my asset allocation series, I explained why adding bonds to your portfolio can help reduce your portfolios overall risk. But bonds are not risk-free (including supposedly risk free U.S. Government Treasuries), and interest rates are the prime culprit.

Bonds Have Interest-Rate Risk

Even if a bond doesnt default (i.e. credit risk), youre still not out of the woods. Another type of risk remains: interest-rate risk. There are two main types of interest rate risk: (1) reinvestment risk, which occurs if interest rates fall; and (2) principal risk, which occurs if they rise. Take, for example, a new-issue 10-year U.S. Treasury note that sports a yield to maturity (YTM) of 2.95%. The holder receives an interest payment every six months, and the YTM assumes that money can be reinvested at the same rate. But in reality, the money can only be reinvested at the current interest rate, which could be lower. Thus, the possibility that interest rates will fall in the future creates reinvestment risk.

Principal risk occurs if interest rates rise in the future. The price of a bond moves in the opposite direction of interest rates. If interest rates rise, the bond price declines. This is only a problem if you need to sell your bond prior to its maturity, because at maturity, you are guaranteed a return of your investment principal (assuming you bought a new-issue bond where your investment cost equals the par value of the bond). But unforeseen cash needs do occur, and you may need to sell your bonds prior to maturity. If you have to sell, rising interest rates will cost you.

Bonds Offer Higher Yields

Given these risks, you may be wondering why you should bother with bonds at all; why not just keep cash in ultra-safe money-market funds? The short answer is that you will be forfeiting yield. The vast majority of the time, the yield curve the relationship between interest rates and time to maturity is upward-sloping, meaning that the interest rate you receive increases the longer you are willing to lend the money.

This makes sense because the destructive power of inflation compounds over time, and investors consequently demand higher interest rates to compensate for greater inflation risk. Higher inflation does not always materialize, though, so investors who are willing to lend money for a longer term are sometimes amply rewarded.

Ah, but that darn interest rate risk. But Ive got good news: Theres a way to combat it: bond ladders.

Bond Ladder to the Rescue!

Fortunately, there is a way to reap the reward of longer-term debt investing (i.e. higher yields) without incurring all of the interest rate risk inherent to bond investing: bond ladders.

As with stock investing, the key to successful bond investing is risk reduction through diversification. A bond ladder is nothing more than a diversified portfolio of bonds with different maturity dates. Each rung of the ladder is a bond of a specific maturity date and the height of the ladder is the difference between the shortest maturity bond and the longest maturity bond. The more rungs in your ladder (10 or more is best), the better the diversification, the more stable your yield, and the higher your average yield.

To illustrate, Ive set up a hypothetical 10-rung bond ladder, assuming an upward-sloping yield curve:

Bond Maturity Date