Creating a Bond Ladder
In the past we have discussed bonds as suitable for capital preservation investments and their market performance and interest as a reliable income stream. Today I am going to talk about creating a "Bond Ladder".
While bonds are subject to several types of risk, two of the main types are interest rate risk, or the risk that interest rate changes will change your bond's value, and reinvestment risk, which is the risk that principal cannot be reinvested at the current bond's interest rate. It is difficult to simultaneously reduce both risks, since a rise in interest rates reduces reinvestment risk and increases interest rate risk. Thus, you need to find a balance between the two risks.
Using a bond ladder strategy can help investors strike this balance. The idea of a bond ladder is pretty simple: instead of investing in bonds that all mature at roughly the same period of time, or in a haphazard pattern of maturities that try to predict the movement of future interest rates, you spread your portfolio out in roughly equal amounts over maturities that are evenly separated from one another.
For instance, a $100,000 portfolio might consist of 10 different bonds of $10,000 each, maturing in 10 consecutive years. When a bond matures, the principal is reinvested in another bond at the bond ladder's longest maturity date (10 years in this example).
If interest rates are then higher, your annual bond income will go up; if rates go down across the board, your income will still benefit from the relatively higher rates on the rest of your portfolio. In either case, because 80% of your portfolio is still throwing off the same cash flow, your annual income won't change very much, which makes your life more predictable than if all of your bonds matured in 2012, or in any other single year.
Decide on the average maturity. This will be a mathematical average of the maturities you use to build your portfolio, which will determine your portfolio's overall price sensitivity to changes in interest rates.
Decide on how many rungs your ladder will have. This will determine how much of the span of available interest rates you'll be capturing (shorter maturities tend to come with lower interest rates and longer maturities with higher rates).
Decide how many years apart each rung will be. This will determine how often you'll be reinvesting in the long-maturity end of your portfolio. The closer together the rungs, the more often you'll be buying longer bonds at current market rates. Depending on which way rates move, this can help or hurt you.
Decide on the sector or sectors of the bond market you want in your portfolio. Do you want safety? Then go with U.S. government bonds. Do you want tax-exempt income? Then go with municipal bonds. Do you want a higher level of interest than either of these sectors provide, but still want financially reliable issuers? Then go with high-grade corporate bonds.
The major advantage to laddering is to smooth out the changes in the bond income you receive year-to-year, thus making it more predictable. But there are also downsides to laddering. One is that you will have more transactions than a portfolio with one, far-off maturity date. And it may also generate less income than if you put all of your money into the highest-yielding maturity available. The trade-off is that if rates rise significantly long before your bonds mature, you're stuck with all of your money earning less than if you were to reinvest funds from maturing bonds in the higher yields.
Once more I will refer you to a professional investment manager to determine the specifics of your portfolio based on your income needs and risk tolerance. They can help you determine what best meets your needs and help with the process of purchasing new bonds as the portfolio matures.
Comments