Bonds Information- Bonds types, Bond & rate, Bond Investment

Investing through a Bond Ladder

More on this topic

Bonds are an important part of any investment portfolio. Bonds usually provide the low risk, fixed income part of your investments and counter more risky investments such as stocks. However, bonds have their own set of risks. Interest rates, for example, can negatively impact bonds. If interest rates rise, bond values may fall. For the individual bond holder, choices range from selling the bond and incurring a loss, or holding onto a bond until maturity and hoping that it can be reinvested at a better rate. The bond ladder, a strategy for investing in bonds, helps to distribute cash flow over time and minimize the detrimental effects of interest rates on long-term bond investing.

The Purpose of a Bond Ladder

A bond ladder is formed when an investor strategically owns a number of bonds with varying maturity lengths and dates. This strategy spreads cash flow over time. Varying bond maturity dates may also help the investor to avoid feeling the negative impact of interest rates all at once. The bond ladder might especially make sense for investors near or in retirement, but it is a strategy that could benefit anyone.

How a Bond Ladder Works

If you buy a group of bonds with varying maturity rates, each bond can be considered a rung on your bond ladder. If you have $50,000 to invest in bonds, for example, you might set up a bond ladder like this: Purchase one $10,000 bond with a maturity of one yearPurchase one $10,000 bond with a maturity of three yearsPurchase one $10,000 bond with a maturity of five yearsPurchase one $10,000 bond with a maturity of seven yearsPurchase one $10,000 bond with a maturity of ten years Maturity increments are set up to meet your anticipated needs for cash flow.

Smoothing out a Potentially Volatile Market

Choosing a bond ladder can allow you to weather the ups and downs of the market, and the effects of changing interest rates on your fixed income investments (such as bonds). If you invested your $50,000 as one lump sum for a period of 10 years, you would be stuck with the single interest rate you purchased that bond at. Additionally, if interest rates fell at maturity, you would be faced with those low interest rates if you wanted to reinvest and buy a new bond. Bond laddering spreads out the risks of fluctuations in the market. Once you set up your ladder, you could have bonds maturing once a year, or in increments of your choice.

Planning for Cash Flow

When you set up your bond ladder, spread cash flow evenly over time by noting when each bond makes coupon payments. These payments are made monthly. For those who need a steady monthly income from their investments (such as retired people), setting up a bond ladder correctly can ensure consistent cash flow over time. While this investment strategy works well for retired people, it may also work well for those who suddenly face financial emergencies in their lives (loss of a job, death, divorce, etc.).

Using the Ladder Analogy

Determine the number of years you need a bond ladder to work for you.

The number of years in your bond ladder represents the rungs of the ladder. If there are more rungs in your ladder, you may be better protected from bond risks such as fluctuating interest rates or bond issuer default.

Determine the distance between the ladder rungs.

This represents how often your bonds will mature. Will bonds mature every few months? Once a year? Every few years? You will need to weigh whether you want easier access to your money (shorter distance between rungs) or higher yields (more distance between rungs).

Determine what the ladder is made of.

Will you invest in safer government bonds, riskier corporate (or junk) bonds, or a mixture of bonds of varying degrees of risk? Can the bond be called back by the issuer, and if so do you want to accept that risk? A bond ladder helps you design and refine your bond portfolio so that you can determine the amount of risk you are comfortable with. A bond ladder manages and regulates cash flow, as well as the effects of the market and of interest rates.

Is a Bond Ladder for You?

Consider your unique financial situation, and ask yourself these questions:

Do you have other investments, and are you diversified in your portfolio?
Are you at an age where including bonds in your investment portfolio makes sense?
What proportion of your investments do you wish to keep in bonds?
Do you have the amount of money needed to invest in individual bonds?
If not, is a bond mutual fund an option that appeals to you?

Additional Resources

Million Dollar Journey’s Web site on how bond ladders work:      http://www.milliondollarjourney.com/how-bondgic-ladders-work.htm
·         Kiplinger’s Personal Finance magazine article on bond ladders: http://articles.moneycentral.msn.com/Investing/InvestingForIncome/SteadyStrategiesForABafflingBondMarket.aspx      ·         Raymond James & Associates on fixed income bond ladders:      http://www.rjf.com/fixed_income_bond_ladders.htm

Related Resources