The bond ladder has another advantages. It is like dollar-cost averaging. As you will be buying bonds on a regular basis you will avoid buying at times of too low interest rate. Imagine buying all your bonds in a recession. You will be locking low returns on your fortune for a long time to come.
A bond ladder has the following characteristics:
1. Bonds with different maturity period. This would mean that the different bonds would mature at different times and that in case you have an emergency you would have access to funds. For example you might have bonds that have a maturity period ranging from one year to twenty years. The key is to have a bond that matures in the next year so that you are able to be able to redeem your capital and use it in case you have an emergency or buy another one to replace the recently matured bond.
2. Bonds that matured at different months of the year. The key here is to have bonds that mature at different months of the year and as a result pay coupons or interests at different months of the year. If you are a retired person, then you would have regular income.
How to build a bond ladder?
Now suppose you have 1 million dollars in you retirement account and you want to build a bond ladder. The ladder will have the following characteristics.
1. The number of rungs. This would be the number of lots that you want to divide your $1million. If you divide the money into ten lots then you will have will have 10 rungs. If you divide the money into more lots then you will increase the number of different types of bonds that you can invest in. See this post on diversification. However the more lots you have, the more would be your cost when you will have to reinvest a matured bonds. The less you divide your money into lots, this would decrease your reinvestment cost. However this would increase the chance of losing a large percentage of your portfolio in case one of the bond issuer default on your bond.
2. The length of the ladder. This would be the longest maturity length that you want one of your bond to have. You might want to have your bonds to have twenty years maximum maturity. The longer the length of the ladder the more return you will have because remember you will have to be compensated for the increased uncertainty. However keep in mind that twenty years is a long time and it increases the chance that you will lose your capital because of default. But keep in mind that too short a maturity will means that you will have to do will low return. That is also not good.The conservative investor might choose twenty years while the aggressive investor might choose twenty years.
3. The length between the rung. You have the chance to make the time between two bonds attaining maturity long or short. If it is too short then it means you are dividing your money into too many lots or have only short term bond maturity. Either way it is not good. The best way is to have the time between maturing bonds of about 1 year. Hence if you have emergency you would be able to survive on the coupon payments until you are able to redeem the materials.
4. The bond ladder should be composed various types of bonds ranging from government, state, municipal and corporate bonds. This is to avoid placing all your money in a single type of bonds. Please read here and here on the importance of diversification.
However, I would strongly discourage against anyone having only a bond ladder. This investment will need to be supplemented with other types of securities to meet true diversification even though you have a bond ladder that is well diversified. You never know what could happen.
Do you have a bond ladder? Please share your experience with us or ask a question by leaving a comment.