Fool.com: Building a Bond Ladder [Retiree Portfolios] July 24, 2000

Retiree Portfolio Building a Bond Ladder

A bond ladder is an effective investment management strategy for the fixed-income part of a retiree's portfolio. Its use helps ensure a more stable rate of return by producing an average interest rate over the period of time covered by the ladder. Finally, the ladder helps preserve investment principal while producing a reasonable income stream during the investment period.

By David Braze (TMF Pixy)
July 24, 2000

In the last two articles, we've talked about how asset allocation may help ease the potential pain of a bear market. I mentioned that money I absolutely know I will use in the next five years does not go into the stock market. In the short-term, stocks may decline quite steeply. The possibility of such a decline is a risk I, as a retiree, wish to avoid. Having to sell stocks at a loss to raise income I need in retirement appeals to me almost as much as receiving a poke in the eye with a sharp stick or having to change two flat tires in the middle of a raging thunderstorm. Therefore, I keep money I know I will use as income in the next five years invested in interest-paying instruments like certificates of deposit (CDs), U.S. Treasury bills, money market funds, and short- to intermediate-term bonds. In an earlier article, I discussed how I compute the income need. Using these prior articles as background, then, it's now time to talk about building a bond ladder.

A bond ladder is a catchall phrase for a strategy to manage fixed-income (or interest-paying) investments. The term "fixed income" means the security will pay a set rate of interest, established when the instrument was first sold, so the annual income or earnings is the same (or fixed) throughout the life of that security.

Fixed-income securities have maturity dates. When they mature, we get our original investment back, which is used to purchase new securities. If all our money is invested in securities that mature in the same year, then at maturity we must reinvest at whatever interest rate prevails at that time. If interest rates have fallen since our original purchase, then on reinvestment we must either accept less interest income or invest in another security that has a greater risk. That's called reinvestment risk. In general, securities with longer maturities pay a higher interest rate than those with earlier maturity dates. But, the higher the interest rate paid, the greater the potential risk of loss.

A bond ladder lessens the effect of reinvestment risk. The strategy requires us to invest an equal amount of money in securities that mature on different dates. As an example, my strategy would be to invest the first fifth of my fixed-income money in a security that matures one year from now, the second fifth in a security that matures in two years, the third fifth in something that matures in three years, the fourth fifth in a vehicle that matures in four years, and the last fifth in a security that matures in five years. Each maturity date represents a rung on my bond ladder.

The bond ladder produces a much more stable return because only a portion of the portfolio will mature at any one time. If interest rates decline, only a small part of our total fixed-income investment is subjected to the lower return. The remainder of our portfolio continues to earn a higher income due to earlier purchases of securities with a higher interest rate. Conversely, if interest rates rise, then part of our portfolio will always mature at a regular interval, which allows us to take advantage of those higher rates with that part of our investment. In doing so, we are able to increase the yield of that portfolio.

Just as we are unable to predict the direction of stock market prices, we are unable to predict the direction of interest rates. A bond ladder allows us to avoid committing all of our resources to a single rate of return. Instead, it allows us to average those rates over time and provides for a steady stream of principal that we may reinvest at prevailing interest rates as our securities mature. By using the ladder, we avoid the reinvestment risk of committing to a single lower rate of return over the total period of our bond ladder.

If you use a relatively short ladder, as I do, then one way to construct it is by using CDs. Those instruments can be purchased without fee at many banking institutions with maturities as low as six months to as high as five years. Alternatively, for a slightly higher rate of return and a minimum investment of $1,000, you can use Treasury bills that mature in three-, six-, or 12-month intervals, or Treasury notes that mature in two, three, five, or 10 years.

Both are available at original issue via a Treasury auction -- which the public may access using the Treasury Direct purchasing system. However, the Treasury Direct option is not available if the investment is to be made within an Individual Retirement Account (IRA). Purchases of U. S. Treasury securities within an IRA must be made through a broker who will charge a fee for the service, typically a minimum of $45 or more.

In addition to using CDs and Treasuries, any broker can construct a bond ladder of any length using government and corporate securities purchased at original issue or in the secondary market. Note, though, that the brokerage option will almost certainly be the most expensive way to establish your ladder.

As you no doubt recall, within the Reasonable and Reluctant retiree portfolios I use two Vanguard bond index funds for my fixed-income investments. I gave the rationale for those choices in the article How We Use Bonds. Still, the use of bond funds may not be appropriate for some folks. That's because of the "interest rate risk" associated with fixed-income securities in general, and bonds in particular. As interest rates rise, the sales price of a previously issued bond that has not yet reached maturity will fall, and vice versa. If you hold that bond to maturity, then the current market value of your holding is unimportant because you will get your principal back at maturity. Additionally, you will always earn the rate of return on that security as set at the time of purchase. With bond fund shares, though, there is no maturity, nor is there a fixed rate of return on the principal. The current market price for fund shares fluctuates as interest rates do. Thus, principal may decline in a bond fund.

It appears, then, that using individual securities may be better than using a mutual fund composed of those securities. Is that always true? According to a Charles Schwab article on that exact issue, an investment of less than $50,000 will probably be more cost-efficient when made in bond funds as opposed to individual securities. The article stresses that you can readily build a diversified bond ladder more cheaply with $50,000 or more, but to be effective those securities must be held until maturity.

So, there you have it, the basics of why to use and how to build a bond ladder. It's definitely not rocket science, just common sense. Once built, the only maintenance required is to replace the securities as they mature by buying new ones that mature as the longest-term rung on your ladder. In my strategy, that means each year I would purchase a security that matures in another five years. By holding these securities to maturity, I maintain the value of my principal while still earning a reasonable rate of return. All in all, that's not a bad fit with the level of market risk I'm willing to take.

I'll close this column on a quick personal note. Based on my column Your Health and Your Retirement, many of you have asked how I am progressing. I'm happy to report that I will finish radiation therapy on August 3, 2000, after 33 zaps by the ray gun. Let it be known that, from a physical perspective, I now give new meaning to the term "red neck." I have been tobacco-free since May 31, 2000, and intend to remain that way. I'm told that doing so gets easier as time goes by, because only the first 30 years are the roughest. I believe that's true, too.

Fortunately for the therapy and unfortunately for the wardrobe, not smoking apparently has changed both my metabolism and my diet, because I have gained 16 pounds over the last 50 days. That has bemused my oncologist because I'm supposed to lose -- not gain -- pounds while undergoing treatment.

Lastly, and to the unending delight of Mrs. Pixy, I have now been deprived of my speaking voice in its entirety due to the radiation therapy. While I am assured that it will return when my treatments cease, I find my muteness an immense irritation, especially when Mrs. Pixy decides to harass me knowing full well I'm unable to respond. That's all right, though. You know what they say about paybacks, and her day will come.

All in all, I am pleased to say that things are as fine as frog's hair. See you next week. Until then, post away as usual on the Retired Fools board.

Best to all...Pixy