Today, we’ll explore bond ladders: what they are, how they work, and the many ways they could help safeguard your retirement income plan.
Building A Bond Ladder
Investors build bond ladders to accomplish two primary goals:
- Generate income
- Mitigate ongoing risk
Building a bond ladder can be a dynamic strategy for creating a solid cash-flow plan in retirement, diversifying fixed-income investments, managing fluctuating interest rate risk, and managing the overall risk of an investment portfolio.
A bond ladder is a strategy formed by purchasing bonds with overlapping maturity dates and housing them in one portfolio.
First, let’s look at bond ladders on a small scale. For example, say you have $300,000 to invest and buy 10 bonds, each with a $30,000 face value that mature periodically over the next decade:
- 2 mature after 1 year,
- 3 mature after 4 years,
- 3 mature after 7 years, and
- The remaining 2 mature after 10 years.
That is an example, albeit a small one, of a bond ladder! Once any bond in the ladder reaches maturity, you can reinvest the proceeds into a new bond, thus, extending your ladder.
Building a bond ladder certainly isn’t the only way to broaden your fixed-income horizon. You can also invest in bond mutual funds and ETFs, which provide greater access to different types of bonds. Investing in a bond fund is also smart for investors who don’t want to shell out a bunch of upfront capital to create the ladder.
Since investors “ladder” their investments, they don’t place all their eggs in one basket, which is critical in varying interest rate environments.
For many investors, the ultimate goal in building a bond ladder is to produce steady cash flow year to year—an essential variable in your retirement plan.
Why Climb The Bond Ladder?
On the surface, it’s easy to see why investors would be interested in a bond ladder—steady cash flow, diversification, and added risk management. But how does this strategy actually work? What goes on behind the scenes to make a bond ladder effective?
First, investors can better control their cash flow by selecting bonds that pay their desired coupon rate or regular interest payments. The coupon rate is the periodic payment made to investors, usually on a semi-annual or annual basis.
Say you have a $10,000 face value bond with a 5% coupon rate. In this case, you would receive $500 a year. A bond’s coupon rate is fixed, making it a steady stream of income.
Next, investors aren’t locked into one single type of bond. There are so many different types of bonds on the market (corporate, municipal, treasury, etc.), constructing a ladder opens up the opportunity to invest in various kinds.
A ladder also gives the flexibility to invest in bonds with different maturity dates. Managing this factor is critical when you start to look at varying interest rates, and corresponding bond prices, throughout the year.
Let’s look at a quick bond recap:
- Bonds are a fixed-income investment vehicle representing a loan from an investor to a separate party (government or corporation).
- Bond prices and interest rates are inversely related, meaning when interest rates rise, bond prices drop and vice versa.
- Bond yield is the relationship between the bond price and its return (the principal and interest coupon payments). In general, when interest rates rise, so do bond yields.
Bonds’ relationship with interest rates is what makes bond laddering such an impactful strategy. The longer you have until the bond’s maturity date, the more uncertainty and changes in interest rate, bond prices, and corresponding yields. If you have different bonds maturing every couple of years, your entire investment doesn’t hinge on one type of bond environment.
Now that you’re more accustomed to a bond’s relationship with interest rates, how do bond ladders seek to offset both high and low-interest rate climates?
The state of bond ladders when interest rates are high
First, let’s go back to our bond recap. When interest rates rise, bond prices fall. But what happens to bond yields? They tend to increase. This means that you can purchase a bond for a lower cost and potentially receive a higher overall return.
Since bond ladders are constantly in flux, with bonds maturing more regularly, you have room to reinvest in bonds with higher interest rates, adding more rungs to your ladder.
Can bond ladders protect your investments when interest rates fall?
Declining interest rates drive bond prices up while also decreasing yields. This situation isn’t always beneficial for bond investors because any maturing bonds may be reinvested in funds with higher prices and lower rates. But fear not; with a ladder, you likely have several other bonds generating income at higher rates.
How To Construct A Bond Ladder
While bond yields and interest rates can make your head spin, establishing a bond ladder isn’t all that cumbersome.
In general, you need to make three critical decisions.
- Rungs—the number of bonds you need in your ladder. To get a better idea, start by dividing your total investment by the number of years you need the cash flow. Let’s go big picture and say that you are investing $200,000 and want the cash flow to last 20 years. In this case, you might have 10 rungs of $20,000 each maturing every 2 years.
- Ladder height—the spacing between rungs, a.k.a the length between bond maturity dates. Depending on the investor, this number could be months or even years. Typically, the rungs are relatively evenly spaced, but that could change depending on your goals.
- Securities—the individual bonds needed to construct your ladder. You can fill your ladder with different types of high-quality bonds like varying company bonds, municipal bonds, government bonds, among others. You can even add other securities like certificates of deposits and treasuries.
Top Considerations For A Sturdy Retirement Bond Ladder
If a bond ladder is part of your investment plan, you should construct it with precision and care. A bond ladder is only as strong as the strategy that supports it.
Below are a few ideas to keep in mind to help you build a sturdy ladder and help it withstand the elements.
- Use high-quality bonds. Typically stay away from high-yield bonds as they are more likely to default, throwing a wrench into your steady income stream. You may also want to avoid callable bonds as the issuer can redeem them before maturity, which means interest payments could abruptly stop.
- Understand your cash flow needs. What other sources of income will you have in retirement? What does your current retirement budget look like? How much will you rely on the revenue from the bond ladder?
- Decide on a time frame that works for you. Do you want the ladder to last 5 or 10 years, or do you want it to last throughout your retirement? Getting a clearer picture of your time frame will help you and your advisor create an income and investment plan that works for you.
- Hold your bonds until maturity. It’s tempting to switch up your investments based on daily changes, but with a bond ladder, it’s critical to ride market waves. Why? Doing so will help you achieve the top two goals we discussed at the beginning of the article: regular income and risk management.
Bond ladders certainly aren’t the antidote to market volatility; instead, they present another way to diversify your portfolio. And diversification is a critical component to a healthy, long-term portfolio.
We love working with pre-retirees and retirees to create an investment plan designed to help them reach their goals. Should a bond ladder be part of yours?
Let’s talk more about it together.