Laddering Bonds: Basics To Know
Volatility of income can be as much a concern as volatility of growth, perhaps more so since income is an immediate need. Therefore, it makes sense that a strategy to stabilize income is a necessary component of portfolio management - and ?bond laddering? can help get you there.
Let's first understand that short-term interest rates are generally lower than long-term interest rates. In simple terms, the longer the maturity on a bond, the more risk you take and, therefore, the higher the interest reward for that risk.
We also know that, over time, interest rates will change. Sometimes they're going up, sometimes they're going down, but they're always doing something.
Finally, no investment objective lasts forever - and opening ?windows? of liquidity can help meet our changing needs.
Building a bond ladder can be a simple way to accomplish the above.
We'll start with the length of the ladder. If our income need is long term, we can go out as long as 15 years. If our income need is shorter, we can adjust accordingly.
The rungs of the ladder are the bonds themselves and, to keep our ladder from falling apart, the bonds should have equal weighting.
Next, we'll need to know how far apart to space our rungs. One year maturity spacing gives more liquidity ?windows?, less income volatility, and greater bond diversity - but, in some cases, this may be impractical. Two year rungs are not going to work for short term ladders, but may have some application for the longer term.
When a rung (i.e., bond) does mature, you can either put the proceeds in your pocket, or you can reinvest the proceeds into another type investment, or you can buy another bond to extend the ladder.
That was pretty easy, huh?
Ok, one more ingredient before you actually start buying bonds.
Most bonds pay interest semiannually. Most investors like income somewhat more frequently. If that's the case with you, pay attention to when the payments are made.
I like to set up a spreadsheet that covers both the dates of maturity and the dates of payment. If I buy a bond with a three-year maturity that pays in March and September, I'll avoid those payment dates when I purchase other bonds with other maturity dates.
Naturally, you can stagger payment dates to suit your lifestyle. Property tax payments, quarterly income tax payments, even holiday spending might create a situation where you overweight your monthly payments.
Now our ladder is complete, and we can take a look at the results.
Income is being paid on a regular basis and the composite interest rate is near the middle of the yield curve.
When a bond matures, you have the flexibility to rethink your investment options.
If buying another bond is necessary, you'll find that there is little disruption in absolute income because most of your portfolio weighting is still intact.
Sometimes it is the simple stuff that works best.
Copyright 2005. LivingTrustNetwork, LLC. All rights reserved. http://www.livingtrustnetwork.com
About the Author: Glenn (?Chip?) Dahlke, a senior contributor to the Living Trust Network (http://www.livingtrustnetwork.com), has 28 years in the investment business. He is a Registered Representative of Linsco/Private Ledger and a principal with Dahlke Financial Group. If you have any questions or comments, Chip would love to hear from you. You may contact him by email at email@example.com