Bond Ladders or Bond Interest – for passive earnings
What is a bond ladder?
A bond ladder is a portfolio of individual bonds that mature on different dates. Picture a ladder with several rungs and spacing between the rungs. The individual bonds are the rungs and the time between maturities is the spacing between the rungs. Below is an illustration.
Building Bond Ladders for Income
- Bond ladders can help investors earn current income and have the flexibility to reinvest in higher-yielding bonds if interest rates rise.
- Investors often build bond ladders to help generate predictable cash flow and help reduce some of the volatility resulting from rising or falling interest rates.
- Find out how to build a bond ladder.
A bond ladder is built with two primary goals in mind:
- Reduce risk. By staggering maturity dates, investors avoid getting locked into a single interest rate. For example, say an investor bought a single five-year bond. If interest rates were to rise two years from now, the bond would still be paying interest at the lower rate.
- Manage cash flow. A bond ladder also helps to manage cash flows for particular needs. For example, since many bonds pay interest twice a year on dates that generally coincide with their maturity date, investors can structure monthly bond income based on coupon payments with different maturity months as well as years.
How to build a ladder
The bond ladder itself is fairly straightforward to create. The overall length of time, spacing between maturities, and types of securities are primary considerations when building a bond ladder. They are:
- Take the total amount that an investor plans to invest, with the goal of extending the ladder as long as possible. An additional benefit to having at least six rungs is that an investor can create a ladder structured to generate income every month of the year.
- The distance between rungs is determined by the span of time between the maturities of the respective bonds, which can range from months to years. Generally, the spacing should be roughly equal.
- Just like a real ladder, investors can build their ladders with different materials—in other words, different types of bonds.
How much does an investor need to invest?
- For the most basic ladder with six rungs using relatively “safe” investments such as Treasuries or Certificates of Deposit (CDs), both CDs and Treasuries typically must be purchased in $1,000 minimums.
- Bond ladders can be customized to accommodate an investor’s time horizon and income needs.
- To help boost income, investors may want to add more rungs to increase the maturities on the ladder (remember, longer-term bonds tend to pay higher interest), or add higher-yielding securities like corporate bonds.
- Municipal bonds also may be added for the potential tax advantages—interest payments from municipal bonds are from federal income taxes as well as some state and local taxes.
- It’s important for investors to remember that, adding higher-yielding or longer maturity bonds generally adds risk to the portfolio.
- Building a ladder that includes municipal or corporate bonds may increase the cost to around $30,000 at minimum for a six-rung ladder, as minus and corporate bonds generally trade in $5,000 minimum.
Whatever path an investor takes, a bond ladder can help ensure that his or her eggs aren’t all in one basket, and give:
- Better control over exposure to interest rate risk.
- Predictable access to principal and ability to reinvest it when some bonds mature.
- The opportunity to help manage an ever-changing interest rate environment.