There are a number of financial strategies out there that help you make the most of your hard-earned money when it comes to retirement. One of those strategies is a bond ladder.
A bond ladder is simply a portfolio of bonds with different maturity dates. It’s an investment strategy that has two main objectives:
- First, it helps you mitigate interest rate risk.
- And second, it allows you to create regular cash flow.
Let’s start with looking at how it helps reduce your exposure to interest rate fluctuations: Rather than buying bonds that all mature at the same time, you buy bonds with staggered maturity dates. Once a bond matures, you reinvest those funds in other bond or fixed-income products.
This saves you from being locked into a bond for a long period of time and being subject to the ups and downs of the bond markets. In this way, you’re able to capitalize on increasing and decreasing interest rates.
When it comes to managing your cash flow, the idea is that you’ll use the predictability of bond income to match your cash flow with your need for cash. Building enough rungs into your ladder allows you to count on a monthly income based on the twice-yearly coupon payments with staggered payment dates.
Building a Bond Ladder: How It’s Done
How many rungs will you have in your ladder?
The construction of your ladder starts with an investment amount. Begin by determining how much you want to invest in bonds. Each bond represents a rung on your ladder, and your aim should be to make the ladder as “tall” as possible. The more rungs, the more diversified your bond portfolio will be, which also limits your risk.
In a very simplified hypothetical example, if you have $120,000 to invest in bonds, you could purchase 12 individual bonds at $10,000 a piece, for a total of 12 rungs.
What are your materials?
Next, consider the types of bonds you’ll invest in, or the materials with which you’ll build your ladder. Municipal bonds, government bonds and corporate bonds are a few examples. You can also invest in treasury bonds and CDs.
How far apart will your rungs be spaced?
Finally, you should consider the spacing of the rungs, or the span of time between maturity dates. Ideally, that spacing will be as equal as possible. Remember that bonds with longer maturities bring higher yields, while a shorter bond maturity can reduce your interest rate risk.
Bond Ladders: The Risks
Although bonds are considered relatively safe investments, there are nevertheless risks, including default risk, diversification risk, and the sometimes high costs associated with investing in fixed income securities and bond mutual funds.
Be sure to talk with your wealth advisor to understand every in and out of a bond ladder and to determine whether or not it’s the right investment choice based on your overall financial plan.
Ironwood Wealth Management is here to help you determine the best strategies for fixed income and other investments. It all starts with your financial plan. Contact us today.