Are you looking for your investments to generate income? One approach involves buying individual bonds with staggered maturity dates and building a bond “ladder” to help manage your exposure to interest rate changes.
How does bond laddering work? Here is a simple, hypothetical example.
Suppose an investor buys three $20,000 bonds, with maturity dates in one, two, and three years. A year passes, and the 1-year bond matures. The investor takes the proceeds and reinvests them into a new bond that matures in 3 years. The result: a refreshed bond ladder with a one-, two-, and three-year bond.
In the process, our investor is reinvesting the proceeds from one-third of these bonds each year, an attempt to manage interest rate fluctuations.
Say interest rates trend higher. If they do, the laddering strategy can take advantage of that development. One by one, the investor can replace bonds lower in the “ladder” with bonds that have higher yields. If interest rates decline, the investor has established positions that can take advantage of the rates set earlier.
When interest rates fluctuate, the market value of a bond is at risk – but if an investor holds onto a bond until its maturity date, they will receive both interest payments and its face value, barring default by the issuer.
This example is for illustrative purposes only, is not representative of any specific investment or combination of investments, and does not include fees and expenses associated with bond investing.
Also, bond laddering is a form of diversification, which is an approach intended to help manage risk. Bond laddering does not remove that risk if security prices decline. Any investment intended to realize higher yields typically comes with a higher degree of risk.
You must construct a bond ladder carefully. Input from a financial professional is highly worthwhile here because of several factors.
First, there is the matter of what role the bonds will be held within your portfolio. For example, will they be placed in a taxable or tax-deferred account? Then, there is the matter of what bonds should be bought and from whom. The bonds credit rating is one factor in the decision making, along with the tax treatment of the interest income they promise to generate.
Any bond laddering approach should be thoughtfully considered. Retirees and pre-retirees interested in the concept would do well to explore laddering methods in collaboration with a financial professional.