Bond Strategy 101 - Constructing the Bond Ladder
By Bill Addiss
Traditionally, bonds have been a haven for investor’s “safe” assets. Even the most aggressive trader would recognize the need for bonds in their personal asset mix, whether it be for retirement planning in growth accounts (like a 401k or IRA), or for personal income.
Yet bonds remain a mystery to many investors. For institutional as well as retail investors, one of the most common and easily adopted strategies is called a bond ladder. Once understood, this income generating strategy can be implemented by the individual investor without needing to pay any management or advisory fees.
The Strategy: Building The Bond Ladder
Rather than just investing in one block of bonds to generate income, this strategy involves buying a series of bonds with varying and sequential maturities. For example, rather than just investing in bonds with a 10 year maturity, the investor would instead buy a series of bonds with staggering maturities up to 10 years. For example, investing 20% of your money in bonds maturing every 2 years for the next 10 years.
Initial 10 Year Bond Ladder Setup:
The benefits of investing this way include:
Constant stream of income: This gives the investor a constant stream of income which can be reinvested at prevailing rates, (referred to as “reinvestment risk”). In the illustration above, should interest rates rise, this gives the investor the opportunity to reinvest their coupon/income at ever increasing rates. However, should rates fall, the investor has “locked-in” some of their income in higher yielding assets for as long as the next 10 years.
Regular principal payments to reinvest: When the bond matures, the investor receives the $1000 par value of the bond, (assuming the issuer has not defaulted) to reinvest back into a longer maturity bond. By creating this ladder of sequential maturities, the investor is able to reinvest their principal back into bonds with longer maturities, continuing to create this portfolio of “rolling” investments. This is called “rollover risk” in the world of bond investing.
A bond basically represents a loan to the issuer of that bond in denominations of $1000 (called the par or face value). When the bond matures, the investor receives back the par value they had lent to the issuer. Therefore, the more speculative the borrower is, the greater the rate of interest they have to pay to borrow money, hence the higher the coupon of the bond. Investors can adjust the rate of return on their bond ladder based on the creditworthiness of the bond they invest in and the credit risk they are willing to take. Here are some generalities:
|T’Bills, T’Notes, T’Bonds
||These instruments are backed by the full faith and credit of the US Government. They are considered to be some of the most secure, low risk investments in the world. However, in return for this safety they offer the lowest returns.
|Certificates of Deposit (CDs)
||Although not technically bonds, CDs are loans to banks. Traditionally, banks offer these instruments with maturities as short as 1 month to as long as 10 years, making them very applicable for the bond ladder strategy. These instruments are backed by a US Agency, The FDIC, so they too are considered safe and secure, but traditionally yielding slightly more than Treasure securities.
||A wide variety of corporations issue bonds to borrow money from investors. Based on their rating assigned from a credit agency such as Moody’s S&P or Fitch’s, corporate bonds are divided into two main categories: High Grade (also called Investment Grade) and High Yield (also called Non-Investment Grade, or “Junk” Bonds). The lower the credit quality of the issuer, the higher the interest they will offer to pay the investor to borrow the money, therefore the greater the interest to the bond buyer.
||States, Cities, Municipal Entities
||Like corporations and governments, municipalities often need to borrow money and will therefore issue bonds. Once again, the bond buyer is lending money to the issuer and taking on the credit risk of that municipality. Rating agencies rate municipal bonds like they do corporate bonds, and the more risk the investor is willing to take, (i.e. the lower the rating), the more income they earn. Municipal bonds also have tax advantages to many investors and traditionally are not used in bond ladders constructed in a tax deferred account like an IRA or a 401K account.
The strategy described here is not intended to “hit a home run”. Quite the contrary, it is intended to provide consistent, reliable income in a variety of interest rate scenarios, either rising or declining rates. It is intended to immunize investors from the risk of interest rate changes. Just as importantly, it is a strategy that can be easily implemented by the investor seeking to avoid management or advisory fees.
About the Author
Mr. Addiss develops and facilitates educational programs for a variety of major financial institutions, government agencies and foreign governments.