In today’s low interest rate environment, investors should think that it’s time to start climbing the ladder – the bond ladder, that is. A bond ladder allows an investor to stagger fixed income investments over time to lock in progressively higher rates from bond offerings as they become available. As individual bond offerings mature, the funds are reinvested in new bond offerings. This strategy is one of the primary tools used by money managers and financial advisors who manage fixed income portfolios for their clients, as well as experienced personal investors.
How Bond Ladders Work
Bond ladders are one of the most straightforward types of investment strategies. One approach to creating a bond ladder is to invest a certain amount in a specific type of bond every at a particular interval. For example, you decide to create a bond ladder by investing $10,000 dollars every six months in certificates of deposit (CDs) with a two-year maturity. Every six months, you invest $10,000 in a new CD with a two-year maturity. At the end of two years, you will have invested $40,000 that will be earning the average rate on two-year CDs over that time. Furthermore, your first CD matures at the end of two years and you can roll over the principal to purchase another two-year CD. Because you are only investing 25% of your portfolio every six months, your portfolio will be less sensitive to increases and decreases in the interest rate on your bonds. If you have $40,000 today, you could also set up an initial ladder with a $10,000 CD that matures in 6 months, a $10,000 CD that matures in 12 months, a $10,000 CD that matures in 18 months and a $10,000 CD that matures in 24 months. As each CD matures, you then reinvest in the principle in a new CD with two-year maturities.
You can create a bond ladder out of any fixed-length CD or bond. You could construct a ladder with five-year or ten-year maturities. A CD at a bank is guaranteed up to $250,000 by the FDIC. You could also create a bond ladder out of US Treasury Bonds that bear the risk of the US government. Sophisticated investors may want to consider looking at the inventory of corporate bonds. Note that corporate bonds carry risk and if the company defaults, an investor will likely lose some or all of the invested principal. Of course, these examples merely illustrate a concept that has a great many variations, depending upon the skill level, risk tolerance and time horizon of the investor. Discipline and patience are critical for setting up a bond ladder. For more information on bond laddering, consult your financial advisor.