Editor's Note: This story originally appeared on NewRetirement.
Bonds can be a core, low-risk component of retirement portfolios. However, they do come with one significant risk factor: If interest rates go up, the bonds you already own will plummet in value. A bond ladder strategy can be a way to reduce that particular risk.
What Is a Bond?
A bond is a fairly popular type of investment. However, unlike stocks or equity-based mutual funds where you are buying a portion of a company (or companies), when you buy a bond you are actually lending money to a company or other institution and they are agreeing to pay you the face value of the bond at a predetermined date (maturity date). They will also pay you a predetermined interest rate (coupon rate) over a specified period of time (coupon dates).
In other words, you pretty much know what you are getting back out and when. However, it is important to note that while you know the dollar amount that you will get at maturity, you do not know how much that dollar amount will be able to purchase.
For example, if you know that the bond will pay you $1,000 in five years but the rate of inflation is at 3%, then your $1,000 will only be able to buy $800 worth of goods and services at that time. (Though you will also receive interest payments on the bond.)
What Is a Bond Ladder?
A bond ladder is a strategy of holding a range of bonds (typically five to 10) of different maturities. For example, the first bond might mature in two years, another bond might mature in four years, the next bond might mature in six years, etc.
This strategy is referred to as a bond ladder because the different components call to mind the pieces of a ladder. Using the metaphor of a bond, each individual bond you own is a rung on the ladder and the time between when each bond matures is the space between each rung.
The Benefits of Bond Laddering
Diversify Interest Rate Risk
With a bond ladder, you hold different bonds with different maturity dates and different interest rates. This means that you are not locking yourself into just one interest rate. You have a better chance of being able to capitalize on both rising and falling interest rates by spreading out your maturity dates.
It’s also important to note that the longer the bond maturity date is, the higher the interest rate it typically pays.
Increase Liquidity and Flexibility
A bond ladder offers investors some flexibility and liquidity. Instead of locking up all of your money for a set period of time, a bond ladder enables you to access money at pre-determined junctures (the maturity dates).
Whenever a bond reaches maturity, you have several different choices:
- Use the money.
- Reinvest the money in stocks or some other kind of investment.
- Reinvest the money into another rung on your bond ladder.
Generate Retirement Income
Bond ladders are one way of generating retirement income. For example, if you think that your retirement will last 15 years, with adequate funds you could buy 15 individual bonds — the first maturing in one year and the last maturing in 15 years.
Types of Bonds
Purchasing a wide variety of bonds helps you to diversify away your risk, while also enjoying a higher overall return.
- Treasury securities are the safest bonds you can buy; unless the entire U.S. government collapses, you’re guaranteed to get your money back. However, they have the lowest returns you’ll find in the bond market.
- Corporate bonds are rated according to potential risk, with the very best corporate bonds receiving a AAA rating. Bonds down to BBB quality (or BAA by Moody’s rating system) are considered investment-grade; anything below that is a junk bond. The lower the bond’s rating, the higher the return you can expect (assuming the issuer doesn’t default).
- Municipal bonds can also vary in both their level of risk and level of returns, depending on the financial strength of the municipality that issues them.
For retirees, Treasury securities and AAA-rated corporate and/or municipal bonds should make up the bulk of the bond purchases. Since you’ll be living off these investments, having one or more bond issuers default on you could lead to financial catastrophe. Thus, it’s best to keep your portfolio’s risk level on the lower side.
However, a bond ladder does allow you to push your risk level just a little bit. As a rule of thumb, the more you spread out your bond investments over different bond issuers, the lower your overall risk will become. For example, if you only own bonds from five different issuers and one of them defaults, you’d lose 20% of your bond investment. But if you own 200 different bonds, 40 issuers would have to default in order for you to lose 20% of your investment.
By buying multiple bonds from different issuers for each rung of your bond ladder, you can put a small percentage of your money into lower-quality bonds and take advantage of the higher returns these bonds produce (without grossly increasing your risk levels).
The best place for your bond ladder may be inside a tax-advantaged retirement savings account. If you buy bonds as part of a standard brokerage account, you’ll have to pay taxes on the interest that those bonds pay you. But if your bonds are inside a retirement savings account, you don’t have to pay taxes on the interest until you actually withdraw it from the account (and if you have a Roth account, you will never have to pay taxes on it).
However, three are exceptions to this rule.
- Municipal bonds issued by your state of residence: These bonds are exempt from both state and federal taxes, so there’s no point in putting them inside a tax-sheltered account.
- Municipal bonds issued by another state: The interest on municipal bonds issued by another state is exempt from federal taxes but not state taxes (so if you live in a state that doesn’t charge state income taxes, you can buy municipal bonds from anywhere tax-free).
- U.S. Treasury bonds: The interest from Treasury securities is exempt from state and local taxes but not federal taxes.
Taxes in retirement can get extremely complicated, especially if you have several different retirement savings accounts and multiple sources of income. If you’re not sure which types of bonds would give you the best tax outcome, consult a professional tax adviser (usually a CPA or an enrolled agent). A good tax expert can save you way more on your taxes than you’ll pay for the benefit of their services.
Should You Pursue a Bond Ladder Strategy?
Bond ladders are fairly straightforward, but they are not always the best way to invest your retirement funds.
If you are interested in pursuing a bond ladder strategy, you’ll want to answer these three questions:
- What percentage of your overall assets should be invested in a bond ladder?
- What are the alternatives to a bond ladder (annuities, stocks, mutual funds, bond funds, CD ladders, and more) and are they better for your particular financial situation?
- When a bond matures, what is the best reinvestment decision for you?
You can play with different variables in the NewRetirement Retirement Planner, to see how different rates of returns and access to cash might impact your overall plan.
However, if you are intrigued by bond ladders, you might want to also discuss the strategy with a financial advisor who may be able to help you assess whether or not it is a good fit for your finances. A financial adviser can also advise you on how to best set it up and manage it over time.