A bond ladder uses bonds to protect your money and provide a steady income when you retire. To build a bond ladder, you purchase bonds (not bond funds) so that the maturity dates of the bonds occur over a period of time. This is called asset-liability matching, which means you purchase an asset that will sell or provide income to cover a future expense (such as paying a month's worth of bills after you retire).
Use Bond Ladders for Cash Flow
You can use bond ladders when you retire to provide the funds needed for your expenses each year. For example, a conservative person might take their entire portfolio and buy single bonds so that they mature each year for the next thirty years to meet their cash flow needs.
This would be a 30-year bond ladder. A less conservative person might use a bond ladder to pay bills for only the first five to 10 years.
Use Bond Ladders to Balance Your Portfolio
Suppose you have a moderate risk tolerance and will retire with $1 million. You could take 40% of your portfolio ($400,000) and buy eight bonds. They could each have a face value of $50,000. The first bond would mature in one year and the second in two years. A third could mature in three years, and so on. This bond ladder would last for over eight years. This is a simple example, but it gives you an idea of how it works.
You'll be holding the bonds in your ladder for some time, so you should buy high-quality bonds to make sure they last.
The remaining $600,000 could be placed in stocks (an index fund would be best) to make up the growth portion of your portfolio. If your stocks averaged an 8% rate of return, the $600,000 would grow to just over $1 million over the next eight years. You could then sell $400,000 of stocks again to create a similar bond ladder.
Keep Your Bonds Until They Mature
Historically, existing bond prices go down when interest rates go up. When considering this option, keep in mind that individual bonds work differently than bond mutual funds (although the relationship to interest rates is similar).
If you use individual bonds to form an asset-liability matched portfolio, you will use the principal amount to pay the debt when the bond matures. Although the bond price will fluctuate prior to maturity, those fluctuations will not matter as long as you hold it.
Learn About Bonds and Plan Your Purchases
There are many factors to consider when using bond ladders:
- The credit quality of the bonds you buy is important because the company must be around to pay you.
- The tax characteristic of the interest income could raise or lower your tax bracket.
- The account you buy the bonds in (e.g., IRA or non-IRA) can also affect the taxes you pay.
- You should know how to account for and use the interest the bonds produce before their maturity year.
- You should find a reputable brokerage service or account that can facilitate your bond purchase.
- You should know when to harvest the growth portion of your portfolio.
A better way to use the growth portion of your portfolio is not to wait eight years before selling off stocks to ladder out more bonds. Instead, you'd sell your stocks in years with strong stock market returns. Then, you'd buy more bonds and place them at the end of your bond ladder.
Many people who invest in bonds believe they are more of a challenge to buy than stocks.
In years with poor stock market returns, you would not sell your stocks. If you had many years of poor stock market returns, you might get down to the point of having only two to three years of laddered bonds left. There is nothing wrong with this; the point of making the bond ladder is to keep your money safe and meet near-term cash flow needs. This keeps you from selling your stocks in a down market.
When the bond matures, you know the amount of money you will receive regardless of the movement of interest rates. If you sell the bond before its maturity date, you may get more or less than the initial price of the bond.
Bond Ladder Alternatives
Instead of a bond ladder, you could build a certificate of deposit (CD) ladder with CDs that mature each year to meet your cash flow needs. You could also price both CDs and bonds when you're ready to buy more to see which would give you the highest yield.
Instead of bonds or CDs, you could use a fixed annuity as part of your ladder. But, again, you would want to see which investments, or a combination of them, would provide you with the highest yield on the dates they mature.