A bonds yield is directly related to its maturity the longer the maturity, the higher the yield. The obvious reason is that longer maturities expose the bond to greater risk of interest rate fluctuation. See my article Understanding Bond Prices and Interest Rates.
Should interest rates rise before maturity, the bondholder would be stuck with a below market rate for the term of the bond. The investor could sell at a loss or ride it out and hope to invest the principal at a higher rate when the bond matured.
Say you have a $100,000 bond.
If interest rates go up, your bond will lose value in the open market if you want to sell. On the other hand, if you wait until maturity, interest rates may fall and you will be forced to invest the $100,000 at a lower rate.
Theres a better way to protect yourself against the risks of interest rate fluctuations and at the same time, managed the cash flow from your bond investments (particularly important for retired people counting on the income).
The solution is a bond ladder. A simple device that lets you minimize the interest risk associated with bond investing and manage the cash flow from your investment.
Heres how it works:
Rather than buy one $100,000 ten-year bond, you buy ten $10,000 bonds with varying maturities beginning with one year and going up to ten years.
The result is you have a bond maturing every year for the next ten years. Here are some of the advantages of the bond ladder:
- You have a portfolio of short, mid and long term bonds, which gives you an attractive current yield.
- If interest rates go up, you have a bond maturing soon that you can reinvest at a higher interest rate. You reinvest the maturing one-year bond at ten years to keep the ladder intact.
- If interest rates drop, only a small portion of your portfolio (the maturing one-year bond) must be reinvested at the low rate.
- By choosing the type of bond for the ladder, you can match you cash needs for however long you build the ladder.
You can build your own ladder to fit your particular needs, however here are some guidelines to remember:
- A bond ladder doesnt have to follow the ten-year example I used above. Five years seems about the minimum to take advantage of yield differences. The farther out it goes, the higher your yield will be and the greater the risk.
- Your ladder doesnt have to have rungs every year. You could choose to have bonds that mature at two or three year increments, although this approach lacks the agility to respond to the market that yearly maturing bonds offer.
- The more rungs or bonds on your ladder, the more diversified it will be.
- You dont have to stick with the same type of bond in your ladder. You can mix them up if that suits your needs. Just be sure none of the bonds are callable. See my article Understanding Bond Types.