After more than a year of interest rate hikes by the Federal Reserve, bond yields have risen to levels not seen in more than a decade. The yield on the 10-year Treasury bond has reached 5% for the first time since 2007, drastically up from the 0.50% yields early in the pandemic. What does this mean? It is a great time to take advantage of high bond yields and work with your financial advisor to provide guidance and expertise when it comes to determining how to use bonds in your portfolio.
Bonds are popular among investors as they add stability, diversification, and a steady income stream to portfolios. However, managing individual bonds in your fixed-income allocation can be a bit like walking a tightrope, especially when you’re trying to time the market’s interest rate fluctuations. This is where a valuable tool called a bond ladder comes into play.
What Exactly is a Bond Ladder?
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Imagine a ladder with multiple rungs, and each rung represents an individual bond with its own maturity date. The gaps between the rungs are the spaces between these maturities. The two primary objectives of a bond ladder are:
Risk Mitigation: By spreading out the maturity dates, you steer clear of locking your investments into a single interest rate. For instance, if you bought a single five-year bond and interest rates rise in two years, you’ll still be stuck with the lower rate. But with a ladder, you’ll have bonds maturing at different intervals, smoothing out the impact of interest rate fluctuations. When a bond matures, you can reinvest the principal into a new, longer-term bond, potentially benefiting from higher interest rates.
Cash Flow Management: A bond ladder enables you to orchestrate your cash flows efficiently. Many bonds pay interest semi-annually, usually coinciding with their maturity dates. This means you can structure your ladder to receive monthly income from these coupon payments. As bonds in your ladder mature, you can reinvest the proceeds into new bonds to extend your ladder or allocate the cash for your spending needs.
Building Your Bond Ladder
Creating your bond ladder seems straightforward, but it does require making some strategic decisions. Here are the key steps:
Rungs: Start by determining the total amount you want to invest, and then aiming to extend your ladder as far as possible. For instance, if you have $500,000 in your portfolio allocated to bonds, you could invest $50,000 in ten individual bonds maturing on different months of the year, giving you the opportunity to receive monthly income from the semi-annual bond interest deposits.
Spacing: The spacing between rungs is the time between the maturities of your bonds, ranging from months to years. Generally, try to keep these spaces roughly equal. For example, a one-year spacing could be chosen to maximize your ladder’s longevity with your investment amount.
The length of your ladder impacts your potential income; longer ladders usually yield more due to higher interest rates with longer maturities. However, longer-term bonds also carry higher interest rate risk. By shortening the maturity or spacing between rungs, you reduce both income and interest rate risk. In a rising interest rate environment, the key advantage here is your ability to reinvest maturing bonds at higher rates should interest rates rise. In a decreasing rate environment, locking in a good rate for longer is desirable.
Selecting the Right “Materials”
Just as you can build a ladder with various materials, you can construct your bond ladder using different types of bonds. Consider:
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- Municipal Bonds: These come with potential tax advantages if you are in a high tax bracket.
- U.S. Treasuries: Known for their credit guarantee.
- Corporate Bonds: Typically offer higher yields with various levels of quality (risk).
Avoiding callable bonds (ones that can be redeemed early by the issuer) is advisable. Callable bonds could force you to reinvest in a lower-rate environment, usually after interest rates have fallen. Moreover, be cautious about taking on excessive credit risk, such as high-yield corporate bonds, as they can lead to decreased bond values if they default or experience credit rating downgrades.
How Much to Invest in Your Bond Ladder?
For a basic ladder with six rungs consisting of “safe” investments like Treasuries or Certificates of Deposit (CDs), a minimum of $6,000 can get you started. Remember that CDs and Treasuries often require a minimum investment of $1,000.
To boost your income, consider adding more rungs to extend your ladder’s maturity. Longer-term bonds usually pay higher interest rates, or you can opt for higher-yield securities like investment-grade corporate bonds. Municipal bonds could also be added for potential tax benefits since their interest payments are often exempt from federal income taxes and some state and local taxes. If you do include municipal bonds, consider holding them in taxable accounts.
However, always strike a balance between your income goals and your risk tolerance. Constructing a ladder with municipal or corporate bonds might necessitate an initial investment of around $30,000 at a minimum for a six-rung ladder, as these bonds typically trade in $5,000 minimums. If you’re working with relatively small investments, fixed income mutual funds or exchange-traded funds (ETFs) could be more practical.
What To Do If You Need Cash Before Maturity Date?
While it is best to hold bonds to maturity, in the rare case that cash is needed beyond your emergency fund and bond interest income before the maturity date of an individual bond within your bond ladder, you have a couple of options.
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- Sell a Bond or Partial Bond: You can sell one or more of the bonds in your ladder on the secondary market. After bonds are initially issued, their value will fluctuate like the value of a stock would. Therefore, you may receive more or less than you originally paid. By selling bonds that are closest to their maturity date, you can minimize the impact on the overall structure of your ladder.
- Borrow Against the Bond: You may be able to use a high-quality bond as collateral for a loan from a bank or financial institution. This is a viable option for those looking for quick access to cash without liquidating their investments, but keep in mind this involves taking on debt and often added fees.
The method you choose depends on your specific financial situation, risk tolerance, and investment goals. Carefully consider the impact of selling a bond on your overall ladder and how it aligns with your long-term financial plan. Consult with a financial advisor to ensure you make the best decision based on your unique circumstances.
How Would a Financial Advisor Use Bonds in My Portfolio?
There are a multitude of factors that go into choosing bonds and building a bond ladder. At Wealth Analytics, this process begins by determining your financial goals, risk tolerance and income needs. This helps us decide how much of your portfolio should be allocated towards bonds, which can be further broken down into individual bonds in a ladder and bond ETFs. Then, the art of investing comes into play.
We identify tax-efficient strategies like bond type and asset location to help you get the most bang for your buck. We manage interest rate risk, credit risk, and liquidity risk by selecting high quality bonds and holding them until maturity, ensuring you get the face value of your bond back plus interest. Market conditions change, your goals may evolve, risk tolerance can shift, and tax laws are often revised. We help you adapt your bond portfolio to align with your new goals and the changing financial landscape.
No matter which path you take, a bond ladder can help diversify your portfolio, manage interest rate risk and provide a reliable source of income. It’s an essential tool to ensure your financial eggs aren’t all in one basket and grant you better control over your financial future.