A Bond Ladder Can Lead to a Happy Retirement
A bond ladder is a strategy for managing a collection of individual bonds or CDs. Under this strategy, the maturities and the timing of interest payments of the fixed-income investments are simultaneously staggered – or laddered – at specific intervals. Each of these bonds represents a different rung on the ladder. The rungs are determined by the amount of investments divided by the number of bonds. Most experts recommend bond ladders with at least five rungs. This requires total investments between $10,000 and $50,000.
For example, an investor who puts $50,000 in five different bonds with a face value of $10,000 each has set up a bond ladder with five rungs. Each rung has a different maturity date. The first rung of bonds matures in one year, the second rung matures in two years, the third rung in three years, the fourth in four years and the fifth in five years. In effect, each rung of bonds reaches maturity at an interval of one year.
The distance between the rungs – that is, the interval of bond maturities – can be set anywhere from every few months to a few years. Bonds, however, are long-term investment vehicles that earn higher yields with time. Making the distance between the rungs longer typically results in better yields. The trade-off is that this exposes the investor to reinvestment risks and lack of access to the funds. Making the distance between the rungs shorter reduces the average return.
Financial experts use bond ladders to generate consistent returns and low risk, and to adjust cash flows according to the investor’s financial objectives. For example, the bond ladder can be set up to function as a source of income during retirement..
By staggering the maturity dates the investor also avoids being locked into one particular bond for a long duration, unprotected from bull and bear bond markets. If the investor poured the full $50,000 into one single bond with a yield of 5 percent for a term of 10 years, he or she wouldn’t be able to capitalize on increasing or decreasing interest rates. The bond ladder approach smoothes out market fluctuations because bonds mature at regular intervals.
A bond ladder also protects the bond portfolio from call risk. Call risk is when a bond issuer takes advantage of the callable bond feature and redeems the issue prior to maturity because of the high rate being paid on the bond. In a bond ladder, there is little chance that all bonds in one portfolio will be called at once because the maturities are staggered.
The bond ladder approach can be used for various fixed-income investment vehicles, including debentures, government bonds, municipal bonds, Treasury bills and certificates of deposit. The “ideal” bond for this strategy depends on the investment objectives and the investor’s preference.
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