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How to Create a Bond Ladder

Financial planners and investment managers often talk about an "investor toolbox," a collection of instruments and strategies that help generate income and save for life's milestones, like college and retirement.

Investors might consider adding a bond ladder to their tools. It's a strategy that gets its name because each rung represents a bond maturity that's longer in date. Ladders typically include Treasury notes and bonds, but also higher-quality corporate and municipal bonds when appropriate. Plentiful, actively traded issues are the best fit for bond ladders. Investors ideally hold each issue to maturity, collecting interest payments, and then often reinvest the principal to extend the ladder.

[See top-rated funds by category ranked by U.S. News Mutual Fund Score.]

"Bond ladders can be an effective way to invest for income by creating a predictable income stream," says Richard Carter, vice president of fixed-income securities in Fidelity's brokerage division.

For example, a bond ladder of five rungs includes maturities of two, four, six, eight, and 10 years. In two years, when the first bonds mature, an investor can take that returned principal (and interest) and spend it, invest it elsewhere, or use it toward a new 10-year issue, the far rung of the ladder. In two years, the same decision is made with the next bonds to mature, and so on. If you choose to reinvest, you can continue the ladder indefinitely.

Investors hesitant to take a walk on a bond ladder may opt for a "barbell" strategy. Here, you invest only in short-term and long-term bonds, not intermediates. The long-term holdings should deliver higher relative coupon rates (another way of saying interest rates). But having some principal maturing in the near term creates flexibility should investors want to exit the bond market, says the Securities Industry and Financial Markets Association. Read more at investinginbonds.com.

In a rising interest-rate environment, the principal from expiring bonds is reinvested at higher rates. Even in a falling rate environment, the portfolio is still earning relatively higher interest on the longer-term holdings.

[See Should You Invest in Bond Funds or Individual Issues?]

By contrast, if you own a single bond that matures and you want to maintain a fixed-income investment, you'd make another purchase. But if interest rates and bond yields had decreased in the meantime, you wouldn't be able to generate as much income with the same amount invested. You would have to take on additional "cost" risk.

Bond ladders offer some inflation protection over individual bond ownership. Investors are insulated from a flare-up in inflation and rising interest rates because they'll have regular cash to roll over into new bonds at higher rates. Inflation is among the biggest risks facing bond investors overall; it chews up the value of the fixed payments collected on bonds.

Using a ladder to produce higher yield over the expanse of the ladder is significant in this current environment. Yields remain historically low across much of the bond and stock markets as the U.S. Federal Reserve and other central banks maintain rock-bottom interest rate policy due to global deficit and economic uncertainty.

That said, because yields on longer-term issues remain historically low, you may want to shorten the ladder (you can always extend again later) because you may not be getting paid enough in longer-term yields to compensate for the risk of longer-term exposure. Remember: Inflation eats up returns and yields need to be high enough to offset that effect.

The downside. The effectiveness of bond ladders hinges primarily on whether an investor truly follows a buy-and-hold philosophy. Predictable income and the ability to manage interest-rate and credit risk are tied to holding bonds until maturity. If you have to sell early, maybe for an unexpected expense or because you want to invest elsewhere, you'll be exposed to additional risks.

[See 5 Ways to Measure Investment Risk.]

Some bonds have the possibility of being "called" early, as stipulated by the government agency or company at the time of sale. When a bond is called prior to maturity, its interest payments cease and the principal is returned as of the call date. If you seek to reinvest this principal in a similar bond issue, you may have to accept a lower yield (and lower interest payments) depending on prevailing interest rates. A called bond could pose a hiccup in your cash flow schedule and your expected maturity schedule.

Sometimes, several bonds might be called at once because market conditions that cause one bond to be called presumably might cause other bonds to be called. This can interrupt cash flow and pose reinvestment challenges.

The risk of default should always be a consideration, with the risks higher on corporate bonds compared with government bonds, for instance. If you are diversified among issuers, the default of a single bond within a ladder should have a limited impact on your cash flow. That bond can be replaced, with costs involved, and cash flow maintained. You may be limited to what bonds are available at the time.

Ladders versus mutual funds. Both have pros and cons, and each investor should assess what's the best fit for them. You may opt for a combination, depending on goals and risk tolerance.

Bond funds limit investor control over the timing of cash flow and maturity. However, bond funds can snare capital gains in a bullish bond market (higher prices, lower yields). Funds generally lose value in a rising interest-rate environment, which can reduce your payout. Of course, managers can add new issues at higher rates, potentially boosting the fund's return in the future.

[See Where to Invest in 2012.]

Ladders can have a higher point of entry than funds. Although there is no hard-and-fast rule, investors should think of starting their ladder with around $100,000, Fidelity advises.

Bonds generally must be purchased in minimum denominations (often $1,000) and in order to construct a ladder that stretches far enough in the future and uses a diverse range of bonds, at least $100,000 will be needed to achieve a full ladder.

Keep in mind that the lower the credit rating of the bonds in a ladder, the greater the number of bonds that may be required to diversify against the risk of default. For example, with a ladder composed of corporate bonds, you may want to consider a minimum investment of at least $200,000.

If you can't invest enough to diversify, you may want to look at other income options like diversified bond mutual funds or annuities, Fidelity says.

@USNewsMoney



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