Bond ladders are used to protect your money and provide a steady income when you retire. To build a bond ladder, you purchase bonds (not bond funds) so that the bond maturity dates occur over a period of time. This is called asset-liability matching, which means you are buying assets that you will sell or that will provide income to cover future expenses (like paying bills one month after retirement).
Using Bond Ladders for Cash Flow
You can use bond ladders when you retire to provide the funds you need for your annual expenses. For example, a conservative investor might purchase individual bonds that mature each year for the next thirty years to meet their cash flow needs.
Using Bond Ladders to Balance Your Portfolio
Let’s say you have a moderate risk tolerance and you will retire with $1 million. You could take 40% of your portfolio ($400,000) and buy eight bonds. Each bond could have a face value of $50,000. The first bond would mature in one year, the second in two years. The third could mature in three years, and so on. This bond ladder would last more than eight years. This is a simple example, but it gives you an idea of how it works.
Note: You will be holding the bonds in your ladder for some time, so you should purchase high-quality bonds to ensure they last.
The remaining amount of $600,000 can be placed in stocks (an index fund would be best) to form the growing part of your portfolio. If your stocks return an average of 8%, the remaining $600,000 will grow to over a million dollars over the next eight years. Then, you can sell $400,000 of stocks again to create a similar bond ladder.
Holding Bonds Until Maturity
Historically, the prices of existing bonds fall when interest rates rise. When considering this option, remember that individual bonds behave differently than bond mutual funds (though the relationship with interest rates is similar).
If you used individual bonds to create a portfolio that matches assets and liabilities, you would use the principal amount to pay off the debt when the bond matures. Although the bond price may fluctuate before maturity, those fluctuations won’t matter as long as you hold it.
Learn About Bonds and Plan Your Purchases
There are many factors to consider when using bond ladders: the credit quality of the bonds you buy is important because the company must be able to pay you. The tax treatment of interest income may raise or lower your tax bracket. The account you use to purchase the bonds (such as an IRA or non-IRA) can also impact the taxes you pay. You should know how to calculate and use the interest generated by the bonds before their maturity date. You need to find a reputable brokerage service or account that can facilitate your bond purchases. You should also know when to harvest the growing part of your portfolio.
A better way to use the growing part of your portfolio is not to wait eight years before selling stocks to form more bonds. Instead, you can sell your stocks in years when the stock market has strong returns. Then, you will buy more bonds and place them at the end of your bond ladder.
Note: Many people who invest in bonds believe they are more challenging to buy than stocks.
Alternatives to Bond Ladders
Instead of a bond ladder, you could build a certificate of deposit (CD) ladder with CDs maturing each year to meet your cash flow needs. You can also price both the CDs and bonds when you are ready to buy more to see which will give you a higher return.
Instead of
From bonds or certificates of deposit, you can use a fixed income fund as part of your ladder. But again, you’ll want to know which investments, or combination of them, will provide you with the highest return at their maturity dates.
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Resources:
U.S. Securities and Exchange Commission. “Interest Rate Risk — When Interest Rates Go up, Prices of Fixed-Rate Bonds Fall.”
Source: https://www.thebalancemoney.com/how-to-use-bond-ladders-for-retirement-income-2388522
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