When it comes to fixed-income, most investors aim to generate returns without taking on a lot of risks. This is especially the case for people in or near retirement who need to generate investment income to meet their living expenses.
This becomes difficult when interest rates are low. When savings accounts, CDs, and bonds are not yielding much interest, it is not easy to find an alternative without taking on a lot of additional risks or locking yourself into long-term rates. A laddered fixed-income portfolio strategy may help.
How a Laddered Portfolio Works
With a laddered portfolio, you buy several individual fixed-income investments with different maturity dates, from very short-term to longer-term. It's kind of like dollar-cost averaging. Having a variety of bonds or CDs maturing at different times can help you get higher rates of return than the average savings account, but it also keeps your money flexible if interest rates rise during the next few years.
Instead of locking everything in at today's rate, you are never a year away from a portion of your money, which can be reinvested at higher rates.
How to Build a Laddered Portfolio
If you drew a laddered portfolio strategy on paper, it would look a lot like an actual ladder. You can think of the elements of the ladder in the same way. Your material is the type of investment you will use to build the ladder. The steps are the number of investments in the ladder. The spacing is the time frame over which those investments mature.
The Materials: Bond Ladder Investments
You can use fixed income investment to build a laddered portfolio. A ladder can be created with a simple investment like a bank Certificate of Deposit, or with short-, intermediate-, and long-term U.S. Treasury bonds.
You could really build a ladder with any type of bond. Investors who want to increase the maturities and attempt to get a higher interest can use corporate bonds, junk bonds, or municipal bonds in a ladder, with the understanding that there is an additional risk.
Municipal bonds, or munis, can offer tax benefits to certain high-net-worth investors. To take advantage of munis’ tax benefits, they should be held in a taxable account.
The Steps: Divide Your Bond Ladder Investments Into Equal Parts
The steps of the ladder represent the amount you plan to invest divided by the number of bonds you plan to invest in. For example, if you were looking for regular monthly income, you might create a ladder with six steps, each one purchased monthly over a period of six months. Bonds typically pay interest every six months. That means that you'd get income in month six, month seven, month eight, and so on through the end of the year.
The Spacing: Buy Investments With Different Maturities
How you space your bond ladder relates to how much time there is between the maturities of each bond. Decreasing the time span between maturities may reduce your potential income, but it also frees up cash flow to reinvest principal as bonds mature.
You don’t necessarily need to build your own bond ladder. There are some bond mutual funds and bond ETFs that work like ladders. Look for funds that buy new, full-maturity bonds each time an older one matures: That’s laddering. Some total market index bond funds even created ladders with Treasuries, corporate bonds, municipal bonds, and other types of bonds.