Bond ladders 101
In the ever-changing world of finance, it's important to have a solid foundation in place. Using a bond ladder is a tried-and-true strategy that can provide you with a steady stream of income and predictable cash flow to match your needs. How does a bond ladder work?
A bond ladder is a portfolio of bonds with staggered maturity dates. When you purchase a bond, you are essentially lending money to the issuer of the bond. In return, the issuer agrees to pay you a fixed interest rate for a set period of time. Then the maturity date is the date on which the issuer will repay you the principal amount of the bond along with the final interest payment.
For example, you may purchase Bond A, a $20,000 bond with a 2.5% interest rate and a 1-year maturity date, you will receive $500 in interest plus your $20,000 principal at the end of year 1. At the same time, you may also purchase Bond B, another $20,000 bond with a 3% interest rate and a 2-year maturity date. With this bond you will receive $600 a year in interest and at the end of year 2 receive your $20,000 principal back (and so on). Those funds can then be re-invested for new bonds with later maturity dates. See below for a brief illustration.
The illustration above assumes you reinvest the bond principal proceeds in new bonds, and then have bond cash flow annually over five years. That’s a perfectly good way to do things, but you also may want to use the proceeds for living expenses in retirement given the reliable timing and ability to plan cash flows accordingly. By purchasing bonds with different maturity dates, you can create a ladder of income that can accomplish this very goal.
In my opinion, the two main benefits of a bond ladder strategy are
- A Steady stream of income: Bond ladders can provide you with a predictable stream of income that you can use to cover your living expenses.
- Less price volatility than bond funds: Bond Ladders are typically held to maturity and bonds mature at par value. This reduces the chance of having to sell bonds for a loss if selling before the maturity date and the price has fallen. Bond funds on the other hand can massively fluctuate with price as interest rates move up and down.
Types of Bonds to Use in a Bond Ladder
There are a variety of bonds that you can use to create a bond ladder. Some of the most common types of bonds include:
- Treasury bonds: Treasury bonds are issued by the U.S. government and are considered to be the safest type of bond investment.
- Municipal bonds: Municipal bonds are issued by state and local governments. Municipal bonds are exempt from federal income tax, which can make them a more attractive investment for investors in higher tax brackets.
- Corporate bonds: Corporate bonds are issued by companies. Corporate bonds are generally considered to be riskier than Treasury or municipal bonds, but they can also offer the potential for higher returns.
Creating a Bond Ladder for You
If you are interested in creating a bond ladder, there are a few things to consider:
- Determine your investment goals: What are you hoping to achieve with your bond ladder? Are you saving for retirement? Funding a child's education? Supplementing your income?
- Choose the right types of bonds: Consider your investment goals and risk tolerance when choosing the types of bonds to include in your ladder.
- Decide on a laddering strategy: There are a few different laddering strategies that you can use. One common strategy is to purchase bonds with maturities that are evenly spaced throughout your investment horizon. For example, if you are investing for retirement, you could purchase bonds with maturities that are 1, 2, 3, 4, and 5 years away.
- Reinvest the proceeds from maturing bonds: As bonds in your ladder mature, you will have the option to reinvest the proceeds into new bonds. This will help you maintain a steady stream of income.
Bond ladders can be a valuable tool for investors of all ages, but especially those in or near retirement. By creating a bond ladder, you can help ensure that you have a steady stream of income to meet your financial needs. If you have any questions about bond ladders, please don’t hesitate to contact us.