Buy-and-hold investors can manage interest rate risk by creating a “laddered” portfolio of bonds with different maturities. When one bond matures, you have the opportunity to reinvest the proceeds at the longer-term end of the ladder. If rates are rising, the maturing principal can be invested at a higher rate. If rates are falling, your portfolio is still earning higher interest on the longer-term holdings.
This makes bond ladders an effective investment strategy for the fixed-income part of a retiree’s portfolio. A properly designed bond ladder matches cash flows with the demand for cash; it also diversifies bond holdings within the portfolio. As the potential for rising rates looms, it may be one of the best approaches we have for fixed-income investing.
Example of a 5-Year Bond Ladder
When creating a bond ladder, investors can choose different strategies depending on their needs.
Barbell Strategy: One type of ladder uses a “barbell” strategy. With this strategy, you invest only in short-term and long-term bonds, not intermediates. The long-term holdings should deliver higher coupon rates. Having some bonds maturing in the near term creates the opportunity to invest the money elsewhere if the bond market takes a downturn.
Bullet Strategy: Another type of ladder uses the “bullet” strategy. With this strategy, you invest for a date and amount needed in the future. For example, if you are 50 years old and you want to save toward a retirement age of 65, a bullet strategy would require you to buy a 15-year bond now, a 10-year bond five years from now, and a 5-year bond ten years from now.
How much income is required?
An individual bond ladder should not be attempted if investors do not have enough money to fully diversify their fixed-income portfolio. We recommend $100,000-$200,000 to start a fully diversified five-year ladder. If you don’t have this recommended amount, purchasing products such as bond funds might be more prudent.
Another option is to purchase Exchange Traded Finds (ETFs) funds that have fixed maturity dates. One way to construct a simple low cost, short-term ladder is by using Certificates of Deposit (CDs); these can be purchased with maturities as low as three months to as high as five years.