5 ways to make a bond ladder work for you

October 11, 2011

http://blogs.reuters.com/reuters-money/files/2011/10/ladder.jpgThe mention of bond laddering often makes one think of retirees sitting on the sidelines of the market, buying individual bonds with staggered maturities to goose up their yields, but lately it’s not such a doddering strategy.

With bond yields low, savings account interest rates microscopic and stock volatility scary, younger investors and even college savers are starting to embrace the time-honored laddering strategy. If can work for people who don’t want to lock up all of their money in long-term investments but want more yield than they can typically get in short-term savings vehicles.

Bond laddering also adds an element of predictability to a portfolio, since each bond produces a set amount of income and returns principal at a specific date.

Stan Richelson, a financial advisor in Blue Bell, Pennsylvania, recently constructed a ladder for a couple whose child was starting college in six years. The first of the four investment-grade municipal bonds, which matures freshman year, has a tax-free yield of 1.5 percent. The last, which matures in 2020, yields 2.35 percent. That translates into taxable equivalent yields of 2.24 percent and 3.5 percent, respectively, for investors in the 33 percent federal tax bracket.

“That may not sound like all that much,” he says. “But you’re still getting a decent return and you know the money will be there when you need it.”

Bond ladders have some limitations, though.

But buying individual corporate and municipal bonds usually requires a total investment of at least $50,000 to $100,000 to get adequate diversification and avoid high markups on small transactions, says Kathy Jones, a fixed income strategist with Charles Schwab. Smaller investors can get around that by  laddering Treasury securities or certificates of deposit, since investment minimums are so low.

Not everything should be laddered, says Jones.  Investors who don’t want to bother selecting individual bonds or CDs may be better off with a low-cost index bond fund, and funds are also preferable for areas of the market that are risky or difficult to access, such as high-yield or emerging market bonds.

Inflation is another issue. A laddered bond portfolio helps investors keep pace with inflation and rising interest rates because when the short-dated bonds come due, the proceeds can be reinvested for longer terms at higher rates. However, because the bonds pay a fixed return they may not increase income as rapidly as a bond fund, which can respond to rising rates more quickly by adding higher-yield bonds to the mix.

But if you’re interested in the laddering technique,  here are some ways to make it more effective and safe in a low-rate environment.

Look to corporate or municipal bonds for better yields.
As a group, investment-grade corporate bonds maturing in six to seven years are yielding 2.4 percentage points more than Treasuries with a similar maturity, which are now yielding about 1.4 percent. Even municipal bonds, which usually yield less than Treasuries because of their tax-exempt status, are yielding slightly more because investors are concerned about state and local fiscal problems.

Compared to other investments, though, investment-grade municipal securities are pretty low risk. Last year only $2.8 billion out of nearly $3 trillion in outstanding municipal bonds defaulted, and most of those were among below-investment-grade issuers.

Jeff Layman, chief investment officer at BKD Wealth Advisors in Springfield, Missouri, feels comfortable stretching for better yields at the higher-quality end of the corporate bond market. “Many companies are in good shape and have lots of cash on their balance sheets so paying off the bonds shouldn’t be a problem,” he says.

The key is sticking with investment-grade issuers rated A or higher. “This isn’t the time to buy high-yield trouble and hope it does okay,” says Layman.

Limit maturities.
Low interest rates have prompted Layman to keep the maximum maturity for most bond ladders at about seven years. “In the past we’ve gone out as long as 15 years on maturities, but there’s not enough reward for doing that now,” he says.

Start with a “barbell.”
“With a barbell you cluster the investment at the short and longer ends of the maturity range,” Jones explains. “If interest rates go up, you can use the proceeds from the shorter-term bonds to build out the middle rungs of the ladder.”

An investor starting with an equal combination of Treasury securities maturing in two years or less and another set maturing in around 10 years might earn a current portfolio yield of a little less than one percent.

“That’s not a lot,” she says. “But it’s better than having your money sit around in cash waiting for yields to go up.”

With state and local fiscal issues in the limelight, Layman believes this is a good time to cast a wide geographic net for municipal bonds, even if it means sacrificing some tax breaks. “We used to have portfolios that were 75 percent invested in in-state bonds because their yields are tax-free at the state level,” he says. “Now, a typical portfolio might have one-third of assets from in-state bonds, and the rest from out of state.”

In the corporate market, where default rates are somewhat higher than municipals, Jones suggests using at least ten different issuers in a variety of sectors such as utilities, financials, industrials and technology.

Plan to hang on until maturity.
This important part of the strategy is particularly relevant in a low-rate environment. If interest rates rise you’ll likely forfeit some of your original investment and lose money to transaction costs if you cash in your bonds or CDs before they mature. You have to be prepared to watch rates move and avoid the temptation to bail out early.


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