Bond Ladders: A Basic Bond Investing Strategy


August 22, 2011

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The decision whether to buy short-term, medium-term, or long-term bonds can be a tall order. One basic strategy is to build what is known as a bond ladder. This allows you to not commit too much money to any particular maturity year. For instance, if you have $100,000 to invest in bonds, the following would be a basic ladder:

2014: $10,000 face value

2015: $10,000

2016: $10,000

2017: $10,000

2018: $10,000

2019: $10,000

2020: $10,000

2021: $10,000

2022: $10,000

In the sample ladder above, you would buy $90,000 of face value spread across 9 different maturity years. Note that if the current offers bonds that mostly trade at a premium, to buy $10,000 of face value will generally cost you more than $10,000 and the opposite goes for discounted bonds.

You would be collecting interest from all of your bonds. You can choose to reinvest the interest at the then-available rates or choose to do something else with the interest [for more municipal bond information sign up for a free account].

Regarding the principal of the bonds, $10,000 is going to mature during the course of each of the years from 2014-2022. Every year until 2022, you will be getting $10,000 that you can choose to invest in new bonds.

For instance, sometime in 2014 depending upon the exact maturity month and date, you will be getting $10,000. If you wanted to maintain the structure of your ladder, you would buy bonds that mature in 2023.

You can build a ladder using any sequence of years with that you feel comfortable with. You can also spread the years out as much as you would like. For instance, maybe you want to buy 2017, 2022, 2027, and 2032.

Generally, the longer you go, the higher the yield. Bear in mind, the longer you go, the greater the fluctuations of a bond’s value. We will cover bond fluctuations in the next chapter.

You can also structure something known as a barbell. With a barbell, you would buy short-term bonds and allocate an equal amount to long-term bonds. With $100,000, this may mean you buy $45,000 of face value maturing before 2017 with another $45,000 maturing between 2025-2030.

2014-2017: $45,000 of face value spread across multiple bonds

2018-2026: $0 ——-

2027-2031: $45,000 of face value spread across multiple bonds

Visually, the weighting of the maturities in the portfolio above looks like a barbell. As the money matures, if you wanted to maintain the shape of your barbell, you would reinvest the money equally between short-term bonds and long-term bonds. For instance, if $10,000 matured in 2014, you buy $5,000 face value maturing in 2018 and $5,000 face value maturing in 2032.

Another useful strategy (also known as common sense) is to simply buy bonds with maturity years for when you know you will need the money. For instance, if you know you will spend $10,000 on a car for your 16 year-old in 2020: Buy a $10,000 bond today maturing in 2020. You could also buy a $5,000 bond and reinvest the interest in a savings account until 2020. (A good bond for this circumstance is something called a zero-coupon bond, which we will cover in a later guide.)

NOTE:

Since municipal bonds are free of federal taxation, they generally do not belong in tax-advantaged accounts like IRAs.

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