How to Create a Bond Ladder

This investing strategy can produce a predictable income stream.

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Financial planners and investment managers often talk about an "investor toolbox," a collection of instruments and strategies that help generate income and save for life's milestones, like college and retirement.

Investors might consider adding a bond ladder to their tools. It's a strategy that gets its name because each rung represents a bond maturity that's longer in date. Ladders typically include Treasury notes and bonds, but also higher-quality corporate and municipal bonds when appropriate. Plentiful, actively traded issues are the best fit for bond ladders. Investors ideally hold each issue to maturity, collecting interest payments, and then often reinvest the principal to extend the ladder.

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"Bond ladders can be an effective way to invest for income by creating a predictable income stream," says Richard Carter, vice president of fixed-income securities in Fidelity's brokerage division.

For example, a bond ladder of five rungs includes maturities of two, four, six, eight, and 10 years. In two years, when the first bonds mature, an investor can take that returned principal (and interest) and spend it, invest it elsewhere, or use it toward a new 10-year issue, the far rung of the ladder. In two years, the same decision is made with the next bonds to mature, and so on. If you choose to reinvest, you can continue the ladder indefinitely.

Investors hesitant to take a walk on a bond ladder may opt for a "barbell" strategy. Here, you invest only in short-term and long-term bonds, not intermediates. The long-term holdings should deliver higher relative coupon rates (another way of saying interest rates). But having some principal maturing in the near term creates flexibility should investors want to exit the bond market, says the Securities Industry and Financial Markets Association. Read more at investinginbonds.com.

In a rising interest-rate environment, the principal from expiring bonds is reinvested at higher rates. Even in a falling rate environment, the portfolio is still earning relatively higher interest on the longer-term holdings.

[See Should You Invest in Bond Funds or Individual Issues?]

By contrast, if you own a single bond that matures and you want to maintain a fixed-income investment, you'd make another purchase. But if interest rates and bond yields had decreased in the meantime, you wouldn't be able to generate as much income with the same amount invested. You would have to take on additional "cost" risk.

Bond ladders offer some inflation protection over individual bond ownership. Investors are insulated from a flare-up in inflation and rising interest rates because they'll have regular cash to roll over into new bonds at higher rates. Inflation is among the biggest risks facing bond investors overall; it chews up the value of the fixed payments collected on bonds.

Using a ladder to produce higher yield over the expanse of the ladder is significant in this current environment. Yields remain historically low across much of the bond and stock markets as the U.S. Federal Reserve and other central banks maintain rock-bottom interest rate policy due to global deficit and economic uncertainty.

That said, because yields on longer-term issues remain historically low, you may want to shorten the ladder (you can always extend again later) because you may not be getting paid enough in longer-term yields to compensate for the risk of longer-term exposure. Remember: Inflation eats up returns and yields need to be high enough to offset that effect.

The downside. The effectiveness of bond ladders hinges primarily on whether an investor truly follows a buy-and-hold philosophy. Predictable income and the ability to manage interest-rate and credit risk are tied to holding bonds until maturity. If you have to sell early, maybe for an unexpected expense or because you want to invest elsewhere, you'll be exposed to additional risks.