Bonds are one the safest investments available. They are used to preserve capital, lower the overall risk of an investment portfolio, or as a way to plan for a future purchase. However, with record low-interest rates, they don’t pay a lot.
Investing in bonds using a ladder is a way to earn a higher rate of return with a portion of your investment coming due each year. Ladders are typically five years in length, but can be as long as you wish, provided you can find bonds matching your risk tolerance and with the maturity dates required.
Bonds are safe because they are contracts between the issuer and investor. Bonds become riskier when the issuer is deemed to be less secure. For example, U.S. Federal Government bonds are the most secure. They receive the highest rating possible, AAA, and the likelihood of them going into default is almost zero. Conversely, corporate bonds are deemed to be riskier. Even well-established corporations will have a higher degree of risk associated with their bonds than those issued by the federal government. As a result of this, corporate bonds often have a higher coupon rate. The coupon rate is the interest to be paid by the bond issuer to the investor.
To begin, first decide how much money you want to invest and how long you want your bond ladder to be. For example, you may want to invest $10,000 in a five-year ladder. This means each year $2,500 plus interest will become available for use or reinvestment.
With that selected you can now choose the bonds you want to invest in. At this stage, you will select bonds with one year, two year, three year, four year and five-year maturities. Invest one fifth of your overall investment in each bond.
At the end of the first year, the bond with the one-year maturity will mature and you will be paid your original investment plus interest. With this money, you now purchase a bond that will mature in five years. At the end of the second year, you do the same and reinvest in another five-year bond. By the end of the initial five years, you will have a bond ladder portfolio all earning the five-year rate.
It is important to remember it will take the length of your bond ladder for it to be in full effect. For example, if you decide to start a bond ladder today and you want it to be five years in length, it will take those five years to be earning the five-year rate on all of your bonds and still have money mature each year.