What is a Bond Ladder?
Chances are that you’ve heard of a CD ladder. This is a strategy that savers use to improve their chances of getting a better overall yield from their savings while still having regular access to their money.
A bond ladder works using similar principles. With a bond ladder, though, the idea is that fixed-income investors can receive a stable source of income for years, while still allowing you to re-invest the money as bond yields rise.
With this approach, you take the capital you plan to invest and divide it between bonds with different maturities. For example, if you have $60,000 to invest, you could divide that up into five bonds of $12,000 each, or 10 bonds of $6,000 each, or anything in between. Then, you buy bonds with different maturities over a range of times that works for your goals.
For example, with a five-bond strategy, you might get a bond that matures in one year, then others that mature in two years, three years, four years and five years. Once the first bond matures, you can buy a five-year bond that will mature in the sixth year of your strategy.
As you can see, the idea is to set up a ladder so that your bonds mature at regular intervals and you can reinvest them. Some investors set up their ladder so they have maturities every two years instead of every year, or they have even longer ladders.
Why Do Investors Use Bond Ladders?
One of the biggest reasons to consider a bond ladder strategy is that it allows you to take advantage of rising bond yields without being locked into one bond for a long time.
Let’s say you stuck all of your money into one bond that matures in five years. But then yields hit lows just at the time your bond matures. If you want to re-invest that money, you’re stuck with all of it at that low yield.
On the other hand, if you have a bond ladder, only a portion of your money would be reinvested in a bond with a historically low yield. The rest of your money would still see higher yields. And, there’s a possibility that when your next bond matures in a year or two, yields will be higher and you’ll be able to take advantage of them.
Another advantage of a bond ladder is that it allows you to manage your bond investments in a way that provides you with somewhat consistent cash flow from the coupon payments. For many people, bonds provide a source of fairly stable income. This can be important for retirees who rely on a portion of their portfolio for the income needed to meet everyday expenses.
When you have a bond ladder, you have different bonds coming to maturity, and you can then use that money to re-invest in other bond products or fixed-income products that allow you to maintain your yield and receive the payments you need. A bond ladder set up even during your working years can work in a pinch to help you smooth your cash flow during times of difficulty, such as when you lose your job and need to look for a new one.
How to Build Your Bond Ladder
Once you decide that a bond ladder is likely to help you reach your financial goals, it’s time to start building. Here are some of the main things to think about as you put together your strategy.
How Many Rungs Do You Want?
Each bond represents a different rung for your ladder. As mentioned above, you divide your money evenly. If you want more rungs, you’ll end up with smaller amounts invested in each bond. This can be an advantage if you want more diversity in your ladder. In our example above, the five-rung ladder had bonds of $12,000 each. However, the 10-rung ladder had smaller bond amounts. There’s a little less risk in a ladder with more rungs, since you have less money in any one security.
How High Should the Ladder Go?
This has to do with how much maturity is between your rungs. If you spread out your ladder over 30 years, you might end up with bonds maturing every five years. Or perhaps you think you should narrow that to one year between bonds.
With ten rungs you could implement a strategy that allows you access to money and a bond every year, working up to a ten-year maturity. Or, you could decide you want access to a portion of your capital every six months, resulting in a ladder that goes five years, but the maturities are such that you can re-invest every six months.
In general, a higher ladder provides you with higher overall yields, since a ten-year maturity usually comes with a higher yield than a five-year maturity. However, the more you space out your rungs, the less access you have to your capital. While you shouldn’t be planning to access your capital regularly (you really want to set up for reinvestment), you might be worried about being able to access liquid funds in a pinch.
What Types of Bonds Should You Use?
Finally, think about the types of bonds that you want to include in your ladder. You don’t have to stick with one type of bond. You can use U.S. Treasuries, municipal bonds and investment-grade corporate bonds. Think about the risks of each type of bond, as well as other factors, including tax status. You want to make sure that the investments you include in your bond ladder match with your other tax strategies and that you’re on track to use your bond ladder in your portfolio in a way that ultimately helps you reach your goals.
Be wary of including certain types of bonds in your ladder, though. For example, callable bonds are those that can be redeemed by the issuer early. You still get your original principal back, but you stop receiving interest payments before the maturity. As a result, you have to figure out where to reinvest the money, and it can mess up your ladder.
Finally, if you’re not interested in managing a bond ladder, you can use bond funds to get regular income from yields.
Bottom Line
If you’re looking for a way to smooth cash flow with the help of bonds, you can set up a bond ladder to help you take advantage of fixed-income investments. However, it’s important to create a bond ladder as part of your overall portfolio goals. Don’t forget that your portfolio should also include stocks and other asset classes in order to help you continue to work toward your goals.
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Source: Doughroller
