Articles: Climbing up a bond ladder
Bonds are often added to a portfolio for greater stability. However, while they are historically not as volatile as stocks, bonds can still be affected by rising and falling interest rates.
Basic premise: If interest rates rise before a bond’s maturity date, you will be saddled with a below-market rate for the term of the bond. In that case, you could sell the bond at a loss or hope to invest the principal at a higher rate when the bond matures.
On the other hand, if you hold a bond until its maturity date, the reverse occurs if interest rates fall: Investors will pay more for an existing bond that hasn’t reached its maturity. The longer the maturity of a bond, the faster the price of the bond rises or falls in relation to changing interest rates.
There is a relatively simple way you might protect yourself against interest rate fluctuations while managing the cash flow from bond investments. It’s called a “bond ladder.”
How it works: Instead of buying, say, 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. As a result, you own bonds maturing every year for the next ten years. This provides a laddered portfolio of short-term, midterm and long-term bonds.
If interest rates go up, you will have a bond maturing sooner that can be reinvested at a higher interest rate. You can reinvest the maturing one-year bond at ten years to keep the ladder going. If interest rates drop, only a small portion of your portfolio the maturing one-year bond must be reinvested at the low rate.
Watch your step; Using a bond ladder is like most other investment strategies. You need to move cautiously and only after you have investigated all your options. Here are a few basic suggestions to follow in the process:
1. Find out when the bonds can be called, if at all. The rules may differ depending on the type of bonds you have acquired. Key point: Know all the details before you invest. As a rule of thumb, you may want to concentrate on bonds that cannot be called.
2. Only invest in high-quality bonds. Be careful about using certain corporate and municipal bonds to build your ladder. Reason: Changes in the credit status of the entity that issues the bonds could mean that you won’t receive your interest or principal on time. Even worse, the issuer may default.
3. A bond ladder doesn’t have to follow the ten-year example used above. For example, you might use a five-year ladder. The longer the ladder, the higher the yield and the greater the risk.
4. The ladder doesn’t need to have a rung for every year. For instance, you could choose bonds that mature in two or three-year increments. But adding more rungs increases the diversification.
Reminder: Seek professional guidance with respect to your investment decisions.
This newsletter/advertisement is produced for our clients, friends and associates through an arrangement with WPI Communications, Inc. for the representatives’ use. Although the editorial content is professionally researched, written and edited, neither our firm nor any of its agents, representatives or associates make any representations regarding the accuracy of the content or its applicability to your situation. The information in this communication is not intended as tax or legal advice. In accordance with IRS Circular 230, the information provided herein may not be relied on for purposes of avoiding any federal tax penalties. Any tax advice contained in the body of this material was not intended or written to be used, and cannot be used, by the recipient for the purpose of 1) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions, or 2) promoting, marketing or recommending to another party any transaction or matter addressed herein. You are encouraged to seek tax or legal advice from an independent advisor.