By Jean Marie Daley
Although there are many benefits to investing, there are also a multitude of risks to it. Some of these risks can be successfully mitigated or managed by employing certain strategies. A significant risk with fixed-income securities is reinvestment risk, or the risk that money received from an investment will earn less when put into a new investment. One way to potentially minimize the risk associated with bonds may be to utilize a bond ladder.
A bond ladder incorporates a variety of individual bonds with different maturities in an attempt to reduce reinvestment risk and provide a steady stream of income. The maturity dates are evenly spaced across a period of time. For example, a portfolio may have a bond that matures in a year, another in three, and another in five. Each bond represents a “rung” on the ladder and the “height” of the ladder is determined by how long the maturities of the bonds extend to. As the bonds mature, the principal can be reinvested into a new bond with the longest maturity of the ladder. The coupon payments received can be used to meet income needs or can also be reinvested into the ladder.
Assume that you want to invest in fixed-income securities, so you purchase a 10 year bond yielding 5%. Until the bond matures, you are locked into that rate and cannot capitalize on increasing interest rate changes. If you were to have utilized a bond ladder with staggered maturity bonds, you are able to smooth out the fluctuations in the market because you have a new bond maturing on a regular basis.
Using a laddering technique rather than an actively traded bond portfolio can provide additional safety. In many bond funds, bonds are being sold mid-term, sometimes at a profit or loss. Since you are holding bonds to maturity in a ladder, you aren’t realizing losses day to day, thus reducing overall market risk.
A bond ladder can be built from all kinds of bonds, like corporate, treasury, or municipal bonds based on the needs of the investor. A municipal bond ladder, for example, can be a good option for those in higher tax brackets that want a more tax friendly stream of income. Certain bonds inherently carry more risk than other, but a bond ladder can be customized to a risk profile. An investor who may have a higher tolerance for risk can invest more in corporate bonds rather than treasuries.
There can be many benefits to implementing a bond ladder, but it can take more capital than just outright purchasing individual bonds or a bond mutual fund due to its very nature of needing multiple bonds to execute it. Creating a bond ladder does takes some important planning and monitoring and is likely only one piece of your overall portfolio. Seeking the help of a financial professional is the best way to identify if a bond ladder makes sense for you.
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The example(s) given are hypothetical and are for illustrative purposes. Actual results may vary from those illustrated