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Scott Burns: Up or down, today’s big worry is interest rates

Q: I believe I understand the effect of interest rates on bonds. But two questions come to mind. First, if you own individual bonds, would you be better off keeping the bonds to maturity and getting the maturity value of the bonds, but losing out on higher rates; or should you sell and reinvest at some point in higher-interest-rate bonds? Second, does this change with bond mutual funds — do fund managers hold bonds to maturity, or do they generally sell and reinvest when interest rates are going up?

J.T., Austin

A: On highly liquid and secure securities such as Treasuries, the market adjusts the price of the bonds so that the discounted present value of an older, lower-coupon obligation would be identical to the discounted present value of a new bond with a higher coupon. Some of the damage done to lower-coupon bonds in a rising-rate market is reduced by reinvestment of the coupons at the new higher rates. You can learn the basics of all this in the classic Inside the Yield Book by Sidney Homer and Martin L. Liebowitz, first published in 1972.

Fund managers vary: There is no standard practice.

Q: What is a CD ladder and how does it work?

J.K., Plano

A: A CD ladder is a series of certificates of deposit with different maturities. They are purchased so that certificates mature at regular intervals, providing principal cash for spending or reinvestment. Ladders are not limited to CDs. You can also build them with Treasury obligations or other fixed-income securities.

A ladder can be built to almost any length. A very simple ladder would start with obligations that mature in one and two years. At the end of the first year, the maturing security is replaced with a new two-year security. The U.S. Treasury sells notes that mature in two, three, five, seven and 10 years, so it is possible, with some after-market purchases, to build ladders as long as 10 years pretty easily. Each year one security would mature. It would be replaced with the longest maturity in your ladder.

In normal markets there are a number of benefits to building ladders for the fixed-income portion of your portfolio, particularly for retirees:

Enhanced income — Once in place, you will enjoy the yield of longer-term securities but have an average maturity that is about half as long. Suppose, for instance, you have a ladder that is built with five-year Treasury obligations. While the average maturity will be about 2 1/2 years, you’ll be enjoying the yield advantage that five-year securities usually have over shorter-term securities. In more normal times, this yield advantage can be significant.

Reduced risk and greater control — With a security maturing regularly, a need for cash need not cause a loss. If you are forced to sell a fixed-income security before maturity, you may have to sell at a loss. But if you have certificates or securities coming to maturity at regular intervals, you may be able to meet your cash needs without a sale. If you substitute the use of a ladder for a mutual fund, you’ll gain control of when your fixed-income investments mature or are sold. With a mutual fund, it’s not your choice.

Simplicity — With a ladder, your fixed-income investing is simplified to as little as one transaction a year: the reinvestment of proceeds from a matured security.

Expense reduction — If you use the ladder as a substitute for a mutual fund, you will save the cost of a mutual fund's expense ratio.

Q: In the event of a U.S. economic crash, how safe is the Fidelity Cash Reserves Fund (Ticker: FDRXX) that is used as a core fund in Fidelity brokerage accounts?

P.W., by e-mail

A: Fidelity Cash Reserves Fund is quite safe by most standards, including Fido’s long history in money market funds. But those concerned with a major liquidity crisis should use a money market fund that restricts itself to 100 percent government securities.

One indication that you are not alone in your concern is that on May 1, Fidelity changed the name of the Fidelity U.S. Treasury Money Market Fund (ticker: FDLXX) to Fidelity Treasury Only Money Market Fund. This fund has a minimum investment of $25,000.

Another fund, Fidelity U.S. Government Reserves (ticker: FGRXX), holds agency securities and repurchase agreements with a minimum investment of $2,500.

SCOTT BURNS is a principal of the Plano-based investment firm AssetBuilder Inc.— Universal Uclick