Let The Investment Compass Help You Build Your Bond Ladder, Today!

    There is a misconception that exists amongst investors that bonds are safe investments and are for our retirement years. Nothing could be further from the truth.

    There are many risks when considering an investment in bonds. There is credit risk or rating risk – the credit rating of the issuer of a bond and the possibility of a change in the creditworthiness of the issuer. There is the risk of time – the longer the maturity of a bond, the greater is the risk that interest rates will change. There is inflation risk (sometimes called purchasing-power risk) – when the rate of inflation rises, bond prices tend to decline as the purchasing power of the bond coupon payments is reduced. There is “Call” risk – the issuer can repurchase their IOU at a specified price (call price) prior to maturity. And, there is also interest rate risk – the changes in the market rates of interest.

    When you construct a bond ladder, you are mitigating a number of these risks. Primarily you reduce time risk and interest rate risk. In today's market there is very little call risk, so that one is also reduced.

    First of all, what is a bond ladder, why are they a good idea and what are the disadvantages?

    A bond ladder is a bond portfolio that has different, usually staggered, maturities. Let's create an example with a $25,000 portfolio. The bond ladder concept would buy $5000 in a 1-year bond which pays 1%, $5000 in a 2-year bond which pays 2%, $5000 in a 3-year bond which pays 3%, $5000 in a 4-year bond which pays 4% and the last $5000 in a 5-year bond which pays 5%.

    The total income from the laddered portfolio will be $750 or 3% for the first year. The income will always be less than what it would be if the entire portfolio was invested in the highest yielding bond, and that is the major disadvantage of the bond ladder.

    When the 1-year bond matures (one year from now) that $5000 would be invested in another 5-year bond which pays 6%. the annual income is now $900 or 3.6% Similarly, two years from now, when the 2-year bond matures, that $5000 would be invested in another 5-year bond which pays 7% the income will increase to $1250 or 5%.

    Bond ladders are useful in that they create flexibility in the bond portfolio. If interest rates are rising as was shown above, the laddered portfolio will participate in the increase in rates and therefore the income from the portfolio will also increase. If, however, interest rates are declining, the income from the bond ladder will also decline. Therefore, bond ladders are a good idea in a market environment of rising interest rates.

    The only benefit that I see to bond ladders in a market of declining interest rates is that you are at least keeping some higher paying bonds in the portfolio, and the income, on average, is higher than the last bond you purchased.

    As stated above, the bond ladders' disadvantage is that the income is less than what you could get if you purchased one single bond. For example, in the bond ladder above, one would expect that the income from the 5-year bond would pay the most interest and the 1-year bond would pay the least amount of interest ( the longer maturity the greater risk). So, if you put your entire $25,000 in the 5-year bond, you would receive $1250 compared to the $750 in the first year of the laddered portfolio.

    At the time, it would be tempting to do just that, however, if you had evidence that rates were going to increase, the laddered portfolio's income will increase. All the while, the risk of the portfolio remains lower.

    The example above is but one version of a laddered portfolio. Another version might have maturities of say, 3-year, 5-year, 10-year, 15-year and 20-year. Looking at the yield curve (a topic for another article) will help make the decision regarding the structure of a bond ladder.

    Another great guide for creating a bond ladder is The Investment Compass. This guidance system will assist you in seeing if interest rates are going up (bonds down) or are they going up (bond down).

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