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It's easy to be put off locking your money up for long in bonds or certificates of deposit when rates are so low—even the average rate on a five-year CD is now less than 2 percent.
But there is a fixed income strategy that can provide you with higher yields: laddering.
Here's how it works: You buy a portfolio of bonds or certificates of deposit at staggering maturities, whether it's over several months or years. As the bonds or CDs mature, you reinvest the proceeds into debt instruments that best fit your income needs.
For example, if you had $100,000 to invest in a bond ladder, you may put $25,000 apiece in a one-year bond, a two-year bond, a three-year bond and a four-year bond (with each bond being one rung of the ladder). When the one-year bond matures, you'd reinvest in another four-year bond if you wanted to maintain the duration of the ladder, and take advantage of higher yields. (Typically, the longer the term of the bond or CD is, the higher the yield.) Regardless, cash would be available to you on a regular basis over that four-year period vs. being locked up in a longer-term bond or CD.
A bond ladder can also provide some protection against rising interest rates. If rates increase, you can purchase higher-yield bonds or CDs with the income from the debt instruments already in your ladder. Many interest rate watchers expect the Federal Reserve to hike rates later this year.
But when building a bond or CD ladder, it pays to shop around.
"I think the biggest mistake that investors, and most advisors, make in building a bond ladder is simply relying on their custodian or broker's inventory to fill it," said Benjamin Muchler, a certified financial planner and managing director at Boston Research & Management. "Bonds don't have a central trading location—they are just inventory items. Thus prices can vary quite a bit between different [firms]."
There are several online resources that can help investors select the best bonds or CDs for their needs when building ladders.
Investinginbonds.com, created by the Securities Industry and Financial Markets Association, offers price and yield information for a variety of bonds and tips on buying and selling bonds. (You can search for yields, ratings and other information on specific bonds at the site's bond center.) You can buy U.S. Treasuries through Treasury Direct. Use Bankrate.com to search for the high-yield certificates of deposit.
Bond ladders do come with some risks. The issuer of bonds used in a ladder could default or, if the bonds are callable, repay the debt before it matures. (Looking for highly rated bonds can help lower the risk of default.)
Some advisors may also build bond ladders using target maturity bond exchange-traded funds (ETFs), which hold a large portfolio of bonds that are expected to mature in the same year, to avoid these pitfalls. "This helps diversify away issuer specific risk," said Brian Power, a certified financial planner and principal at Gateway Advisory in Westfield, New Jersey.
To be sure, creating and maintaining a bond ladder does take some time and effort. Many investors may be better off putting their money into a low-cost, diversified bond fund or having a trusted financial advisor do the ladder construction and risk management for them.
Yet for motivated investors, building a bond ladder can lead to a stable foundation of retirement income.