Unlike a stock that represents ownership of an entity, a bond is a debt instrument that represents a creditor stake (i.e. lender). Governments, corporations and financial companies (mortgages, etc.) sell bonds to raise money. They promise to repay the principal along with interest on a certain date (maturity).
If you bought $50,000 of Bond ABC that is paying 5% and matures in 10 years you would receive $2,500/year in interest and $50,000 back when the bond matured. This is a simple example to explain how a bond investment works.
Unless you buy a bond when it is first issued, you will probably either pay a premium or discount for the bond. A premium / discount means you will pay more / less than par value (maturity value) for the bond. If you pay $51,000 for the above bond, that would be a premium, since you are only going to receive $50,000 back at maturity. If you pay $49,000 for that same bond, that would be a discount.
Interest rates are usually the main factor in determining premiums and discounts. If interest rates drop to 4.5%, Bond ABC is more valuable. After all, why would you pay $50,000 for a bond paying 4.5% interest when you can get one for the same amount paying 5%? As more investors flock to the 5% bond, its price increases. The market adjusts the prices so their yield to maturity is similar. Bond ABC would maybe now sell for $52,000. You’d get a higher interest rate, but you’d have to an extra $2,000 to get it. For investors buying Bond ABC now, that works out to about a 4.5% yield. Again, this is a simple example. Comparing bonds by their yield to maturity is a great starting point, but you also have to consider their underlying investments, creditworthiness, maturity date, and frequency of interest payments when selecting individual bonds.
A bond ladder is the purchase of several individual bonds with different maturity dates. You could own bonds that mature after 1, 2, 3, 4 and 5 years. The bond maturity amounts could be used to fund the next year’s retirement expenses. You could build a variety of bond ladders. You could build a 2-3 year ladder with bonds maturing every quarter, or you could build a 10-20 year ladder with annual maturities.
One of the main advantages of bond ladders is that you know what you are going to get. If you hold the bonds to maturity, your bond maturity amount won’t be effected by rising interest rates. Likewise, you know what interest payments you’ll get, and when you’ll receive them. For a risk averse investor, this can be very comforting.
If you prefer to hold more in cash, a CD ladder could be used to potentially increase yield. A CD ladder works the same way as a bond ladder except the maturities are usually shorter (3 months – 3 years).
These strategies could be used together as well. You could build a bond ladder with maturities of 2-7 years for future retirement income. And then a CD ladder of 1 year, 18 months and 2 years for your Cash Reserve. This would give you 7-years’ worth of known money to cover retirement expenses, while at the same time providing liquidity for unexpected expenses. To keep the bond ladder “rolling”, every time a bond matures, you could use a portion of the rest of your portfolio to buy a new bond maturing in 7 years.
Disadvantages of ladders
Bond ladders can make sense in certain scenarios, but there is often a cost to certainty. Here are some things to keep in mind:
- Bond funds fluctuate in value and are more affected by interest rate movements. Individual bonds mature at a certain value, but you have to hold them to maturity in order to get that value. If you need to sell early, you could get less than maturity value.
- There’s more default risk with individual bonds. Bond funds may hold thousands on bonds, but a bond ladder may only be comprised of 5-15 bonds. In one were to default, that could have a much larger impact than with a bond fund.
- For retail investors, a bond ladder could be expensive to build. Individual bonds usually have markups of 1% - 2%. Unlike the stock market where it is easy to get quotes, it can be cumbersome to try to get several quotes on an individual bond.
- Money markets from an online bank will probably pay more and be more liquid than a CD ladder.
