For years, the value of bonds in a retirement portfolio has been unparalleled. Investors have argued for the low-risk and fair return advantages of bonds against the high risk of equities, especially for retirement-focused investments. However, bonds too have a significant risk. If the rate of interest shoots up, the bonds drop in value. But this risk can easily be avoided by following an investment strategy called the ‘bond ladder’ strategy. A bond ladder is an effective tool for retirement security. It protects the investments from volatility and offers the much-needed peace of mind.
Here is all you need to know about using bond ladders for retirement income:
What is a bond ladder?
A bond ladder is a powerful, multi-maturity strategy comprising a range of bonds. The approach diversifies bond investments by their maturity dates to reduce risk and offers a predictable retirement source of income. In a bond ladder strategy, you are never invested in a bond for a long period. In simple words, structuring a portfolio according to a bond ladder approach means holding a pool of bonds with different maturity dates.
For example, if you have $800,000 to invest in bonds, by applying the bond ladder strategy, you will divide your total funds into four different investments, each with a varied maturity date, assuming two, four, six, and eight years. Each of these maturity dates will be set at a considerable gap to allow the bonds to profit well. Once the first bond investment matures after two years, you can reinvest the same beyond the longest lock-in period of the ladder, which is eight years. Each bond you own with a different maturity represents a step of the bond ladder. The time between two different bond-set maturities is the metaphorical distance between each step.
What are the advantages of using a bond ladder investment strategy?
Here are some benefits of using this strategy:
Reduced risk: In a bond ladder strategy, you invest in multiple bonds, each with a different maturity date. So, when a particular instrument matures, you have the option to reinvest the money in high-coupon value bonds, or use the funds to buy stocks for more suitable returns. This helps you minimize risk of a drawdown because no one coupon-rate affects your returns significantly. In a general approach, when you stay invested in a bond for a long period, you are prone to higher risk because of bearish and bullish market fluctuations.
Better returns: A bond ladder approach offers higher returns than a general bond investment. Essentially because the strategy involves investments for a longer duration, which in turn, has potentially higher profits. Also if you restrict yourself to a single bond for a long time, you cannot take advantage of the increasing interest rates.
Liquidity: A bond ladder strategy involves both short-term and long-term investments. The former allows better returns, while the latter has more liquidity. You can use the funds for a specific purpose or reinvest it as per your financial condition.
Flexibility: By following a bond ladder approach you can easily structure the maturity of bonds to suit your financial situation. This can be more appealing for retirees who need a reliable stream of retirement income.
What are the disadvantages of using bond ladders?
Restricted choice: For the bond ladder strategy to be successful, you must choose high-quality bonds to minimize the risk of default. This limits your choice and you might have to opt for a low-interest rate bond only because of its high security.
Constrained liquidity: The main objective behind this approach is to hold bonds until their maturity to make the most of their interest value. However, in case of emergencies, you might have to sell these bonds at lower prices, which will defeat the purpose of the strategy.
High cost: If you hire a professional broker to buy the bonds on your behalf, you might be incurring heavy transaction costs due to added commission. However, the professional financial advisor that you hire could help you take on the tactic of using bonds more effectively and minimize your risks.
What are the steps to create a bond ladder?
The major elements of the strategy include:
Rungs: Rungs are the individual bonds that have different maturity dates. You can create the rungs of your bond ladder by dividing your total investment by the number of years for which you want to hold the ladder. The objective should be to create a ladder as long as possible. This will improve your returns, enhance liquidity, reduce risk, create higher interest pay-outs, and make the portfolio more diversified.
Spacing: The difference between each rung (bond) represents the spacing of bond maturity dates. The closer the distance between two rungs, the closer is the proximity of two bond maturity dates. Space can represent a few months or several years. However, it is advisable to maintain equal spacing between the rungs. The higher the number of rungs and the difference, the greater will be the height of the ladder. Long ladders have proven to produce higher income because long-duration bonds have greater coupon rates. Moreover, the taller the ladder, the longer will be your investment period. This will enable you to smooth out market fluctuations that affect bond prices. A shorter gap or investment difference between the rungs reduces the return on the bond ladder. But this offers more liquidity and easier access to funds.
Materials: The building materials of the ladder are the bonds that you choose to invest in. It is advisable to invest in high-quality and stable bonds to ensure success in this technique. You can also choose to buy bonds of different companies to diversify risk. Ideally, indexes like Standard and Poor (S&P), and Moody’s can help you find reliable bonds. You could consider investing in bond types like debentures, government bonds, treasuries, certificate of deposits (CDs), municipal bonds, etc. Each type of bond has its own merits and disadvantages. You could pick up ten different types of bonds for the ladder. Additionally, it is important to remember that bonds that can be called off early by the issuer should be avoided.
What should you remember before investing per the bond ladder strategy?
Here are a few things to remember, if you consider investing your money using a bond ladder strategy:
- You should have sufficient funds to be able to diversify the investments.
- It is good to avoid callable bonds that are redeemable by the issuer before maturity. This would risk your interest payments.
- Do not invest in a bond ladder if you cannot keep down the urge to liquidate your money in times of need. Patience is a key driver to the bond ladder strategy success.
- It is best to choose high-quality and reliable bonds backed by trusted issuers and good index ratings. Generally, bonds with A-grade or higher ratings are the best.
Should you create a bond ladder?
A bond ladder is an effective investment approach, which produces regular yields and reduces risk. Moreover, you have more opportunities to reinvest the money to garner higher returns in the long-run. So, a bond ladder helps you build significant low-risk wealth. But the strategy only works if you stay invested until maturity and do not cash-out early, defeating the whole purpose of the bond ladder.
To sum it up
Even though a bond ladder is an easily deployable strategy, the approach must be taken on after careful consideration. Moreover, each rung space, and material should be selected with utmost diligence to create a strong ladder. If you are thinking of creating a bond ladder for your portfolio, trust a professional financial advisor to provide you with the right guidance.
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The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.