Bonds are a key part of every retiree's portfolio. They provide a predictable stream of income, and all but the lowest-quality bonds are low in risk. However, bonds do have a significant drawback: to get the best interest payouts, you have to buy long-term bonds. That means your principal is tied up in the bond for years, or even decades at a time.

However, there's a simple strategy that allows you to enjoy the benefits of bonds and dodge that particular drawback.

Enter "bond laddering"

Bond laddering provides a way to avoid having too much capital trapped for long periods of time, and it also reduces the risk that rising interest rates pose to bond holders. A bond ladder is a set of bonds that mature at different times. For example, to build a simple bond ladder, you might buy a different one-year bond each month for a year. During the next year, you'd have a bond coming to maturity every month, releasing your principal and allowing you to purchase new bonds with it. And because you're regularly making new bond purchases, if interest rates rise, you can take advantage of the improved rates with each new issue.

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Manage your default risk

If you invest all your bond money in Treasury bonds, your default risk is pretty close to zero. But Treasury bonds, while secure, also offer lower returns than any other type of bond. Bond laddering can allow you to purchase somewhat lower-quality bonds while keeping your risk manageable, because your money is spread out across several different bonds and bond issuers. If you're careful to pick bonds from different issuers, you can effectively diversify away the risk of default. Should the worst happen and one of your bond issuers default on you, you've only lost a fraction of your money. And the higher yields from all the issuers who didn't default may even make up for this loss.

Don't fill up on junk

Of course, the ability to diversify through a bond ladder doesn't mean you should stuff your entire portfolio with junk bonds. The whole point of a bond ladder is to give you an ongoing stream of guaranteed income; investing in high-risk bonds threatens that guarantee. Stick to bonds rated "A" or higher, and spread your bond purchases from the lower end of this range out between many different issuers. For example, if you buy A-rated corporate bonds, you should get bonds from at least 30 different companies to keep your risk diversified.

Don't play chicken with the bond market

Most of the benefits that come with bond laddering will disappear if you sell your bonds before they mature. Dumping a bond early puts a hole in your projected income stream and wipes out your protection from rising interest rates. For that reason, you shouldn't put all your available money into bonds; if you have a sudden urgent need for cash and all your money's tied up, you might have no choice but to sell a bond. Having an emergency savings account with a few months' worth of expenses in it is just as important for retirees as it is for workers.

Individual bonds or bond ETFs?

As is so often the case in investing, you can either put a considerable amount of time and effort into choosing your own investments, or you can pay a fund manager a fee to do it for you. Most bond funds and ETFs use a laddering approach for precisely the same reason that individual investors do. And given the enormous number of such bond funds specializing in just about every type of bond imaginable, you can greatly simplify the bond laddering process by picking up two or three ETFs with different bond specializations. For example, you might split your money between a long-term corporate bond ETF, a long-term Treasury bond ETF, and a short-term Treasury ETF.

ETFs have the advantage of allowing you to start small; while bonds often require a minimum purchase of at least $1,000, a single share of an ETF is typically far cheaper. The disadvantage of buying ETFs instead of individual bonds is that it does limit your ability to pick out the specific bonds that best match your income needs. That can make your future income a lot more variable than it would be if you controlled the bond purchases, rather than the fund manager.

Tips for building a DIY bond ladder

If you choose to shun ETFs and create your own homemade bond ladder, the first step is to decide how much money you want to invest across the entire ladder. Most retirees will want to keep some of their money allocated in stocks, using the formula of 110 minus your age to find the percentage of your total investments that should be in stocks. (For example, a 50-year-old investor should typically keep about 60% of their portfolio in stocks -- that's 110 minus 50.) The next step is to decide how many "rungs" -- i.e., maturity dates -- you want in your ladder. However many rungs you choose, splitting your entire investment evenly across the rungs of the ladder will help you to create an even income stream.

A sample bond ladder

Let's take the example of a 70-year-old retiree with $1 million in his retirement accounts. The "110 minus your age" formula says that this retiree should have 40% of his portfolio in stocks and 60% in bonds, so that gives him $600,000 to invest in the bond ladder. He wants to invest in a mix of Treasury, municipal, and corporate bonds, so he decides to pick 20 different issuers in the interest of diversification. After some consideration, he settles on a 10-year bond ladder with rungs every two years, for a total of five rungs. That means he will buy four 10-year bonds from different issuers every two years. Each rung will hold $120,000 worth of bonds, dividing his $600,000 pool of money across the ladder evenly. To build the ladder, he'll buy his first four bonds today, his next four bonds two years and one month from today, and so on (spacing your purchases across different months of the year helps to space out the interest payments, as they're typically made twice a year based on the bond maturity date).

While he waits for the next rung of the ladder to arrive, he can park his remaining bond money in short-term issues to keep it generating some reasonably good returns. At the end of the 10 years, when his initial bond purchases mature, he can either keep the same ladder going by adding another rung or switch to a new bond strategy.

Other considerations

For bond ladders, it's wise to stay away from callable bonds: Should the issuer call the bond early, you'll end up with a hole in your ladder. Also, when deciding between Treasury, municipal, and corporate bonds, remember that interest payments from munis are typically tax-free but tend to yield less; it doesn't make any sense to buy munis inside a tax-advantaged retirement account, as you're already getting the tax benefits on all investments in those accounts. Use standard brokerage accounts to buy munis instead, if you're going to buy them at all.

Meanwhile, most corporate bonds have a minimum purchase amount of $5,000, so if your bond investment money is limited, you're probably better off sticking with either Treasury bonds or ETFs. Finally, consider starting your ladder before you retire. That will maximize the amount of income you get from it during your actual retirement, when you'll really need those dependable interest payments.

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