It’s no secret: investing can be intimidating, and many people just don’t like the idea of “gambling” with their hard-earned savings. Luckily, there are some simple investment strategies that provide a steady stream of income without exposing you to much risk. One such strategy is making a bond ladder. A financial advisor could help you figure out how this fixed-income security could fit into your financial plans.
What Is a Bond Ladder?
A bond is a type of fixed-income security. Specifically, it’s a loan that you provide a company or government as an investor. It has a point of maturity, when the principal amount gets paid back, and a coupon rate, which determines the percentage of the principal that gets paid out at regular intervals between the original investment and maturity. The point of maturity could be anywhere from weeks to months.
Similar to a CD ladder, a bond ladder is a portfolio of fixed-income securities with different points of maturity. Each bond is a rung on the ladder, and the proceeds can be continually reinvested once the bond reaches maturity.
How to Make a Bond Ladder
Creating a bond ladder is fairly straightforward. A financial advisor can help you build one, or you can follow these three steps to do it yourself:
- Step 1: Invest in a range of bonds with different maturity dates. You should select the number of bonds, maturity dates, and securities that best fit your financial situation and goals.
- Step 2: Hold each issue until it reaches maturity, collecting interest payments along the way.
- Step 3: Once each bond matures, you can choose whether to reinvest in the ladder or use the funds elsewhere.
In addition to these steps, here are three basic bond ladder concepts that you will need to learn before investing:
- Rungs: The rungs of the ladder are your bonds. To determine how many bonds you need for your portfolio, divide the total dollar amount you want to invest by the length of time you want the ladder to last. The more rungs you have, the more diversified your portfolio will be and the less risk you take on. Keep in mind that bonds are typically sold in minimum denominations of $1,000 or $5,000. The more money you invest, the higher your interest payouts will be.
- Spacing: The height between each rung represents the proximity of your bonds’ points of maturity. This can range from every few months to several years. Most experts suggest keeping the spacing roughly equal. Longer ladders tend to produce higher income since bonds with longer maturities tend to offer greater coupon rates. Shorter ladders may reduce the average return of the bond ladder, but it also reduces reinvestment risk and increases liquidity. If you have short-term savings goal or think you may need to access the funds in the near future, design your ladder with points of maturity every few months.
- Materials: The materials you make your ladder from are the types of bonds you choose to invest in. As with a real ladder, you want to find stable, high-quality bonds. It’s also important to pick bonds that can’t be called away early by the issuer. Moody’s and Standard and Poor’s ratings can help you decide, but it’s important to do your own research, too. Municipal bonds may have tax advantages and treasury bonds come with a credit guarantee, but corporate bonds usually have higher yields. Just remember that the bonds with the highest yields aren’t necessarily best. You should pick at least 10 different securities to diversify your portfolio.
Pros of Using a Bond Ladder
The ladder strategy is meant to help investors manage their cash flow while limiting their exposure to risk. It can pay off no matter what current interest rates are. Here are three benefits to keep in mind:
- Bond ladders create predictable streams of income: Unlike other investments, bond ladder proceeds are incredibly predictable. You know that you’ll receive your principal upon bond maturation, as well as the amount and date of coupon payments you will earn along the way. That consistency makes it easier to design a budget and prevents you from dipping into your savings unexpectedly or unnecessarily.
- Bond ladders smooth the impact of interest rate fluctuations: By staggering points of maturity, you avoid getting locked into a single interest rate for several years. As different bonds mature, you can adjust your investments based on the market. If interest rates have increased, you can reinvest at higher rates. If rates have fallen, you still have some bonds locked in for the longer term at a higher rate. Laddering also offers protection against inflation, which diminishes the value of fixed payment returns.
- Bond ladders provide flexibility: Perhaps the biggest benefit of bond ladders for newer or more conservative investors, they provide regular access to assets. Whether you have bonds maturing every month, quarter, or year, you can always decide whether you want to extend the ladder by reinvesting that principal into a new longer-term bond. You could also invest in different vehicles now that the credit and interest rate environment has changed. If you need to use the funds for other expenses, you won’t face any penalty.
Cons of Bond Ladders
A low-risk, continuously yielding investment sounds good on paper, but bond ladders aren’t without their drawbacks. Here are two disadvantages to consider:
- Bond ladders do not eliminate all risk: No investment is 100% guaranteed. A bond’s value is dependent on the credit of the underlying company or institution. They can default. Plus, bonds are subject to being called early, which means the interest payments cease and principal is returned. In addition to decreasing overall yields, that can impair your ladder schedule and limit reinvestment options. You can minimize these risks by diversifying your portfolio with only highly-rated securities, but some risk will remain.
- Bond ladders work best with a large upfront investment: Since laddering requires you buy several bonds at once, and most bonds are issues in denominations of $1,000, they have a higher point of entry than funds. While it isn’t a rule, investment experts only recommend making a bond ladder if you have at least $100,000 to invest. Otherwise the ladder will be too short, or the rungs will be too far spread out. If you are only investing in corporate bonds, you may want to purchase even more. Greater diversification will help make up for the higher risk of default.
Bottom Line: Should You Build a Bond Ladder?
Bonds are a relatively low-risk way to build wealth. The ladder strategy helps to maximize their benefits. Since there are multiple bonds with staggered points of maturity, bonds are constantly maturing, producing yields, and freeing their principal for reinvestment or other uses. Of course, bond ladders only work if you hold the bonds until they reach maturity. Selling the bonds early or changing investment strategies expose you to additional risks and defeat the purpose of the ladder.
Investing Tips for Beginners
- A financial advisor can help you determine whether a bond ladder is suitable for your financial situation, and also guide you in choosing securities as you design the ladder. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re new to investing and you want to learn more about different investment options, here are 14 types of financial investments that you should consider in 2021.
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