Since rising rates tend to depress bond prices, the threat of rising interest rates may worry fixed income investors. Investors with this concern may want to consider constructing a bond ladder to hedge against this risk.
A bond ladder is a portfolio of individual bonds with staggered maturities. As the nearest “rung” on the ladder is redeemed, the proceeds are reinvested in a bond with a longer maturity. If interest rates rise in the future, as many observers expect, “rungs” in a bond ladder can be reinvested in higher yielding bonds, raising the investor’s periodic cash flow from investment interest.
Conversely, interest rates might surprise the “experts” and move lower. In that case, the rungs will be re-invested at a lower yield, it’s true, but the investor likely will be glad that he or she has locked in higher-than-current yields with her bonds on the later rungs.
Taxable or tax-exempt
Investors often use tax-exempt municipal bonds for their bond ladders. When they do, the bond ladder should be held in a regular taxable account to take advantage of the tax break. Bonds issued within the buyer’s state of residence often avoid state or local income tax as well as federal tax.
For IRAs and other tax-deferred retirement accounts, bond ladders generally should be constructed from corporate bonds or other taxable issues. Yields generally are higher than they are in comparable municipal bonds, and those yields can compound inside the tax-deferred plan.
You shouldn’t expect huge profits from a bond ladder. Instead, you should consider a bond ladder as an arrangement that could possibly improve portfolio income and stability over a long period of time. Every year, you can expect an untaxed bond redemption that you can spend or save as you choose.
This article carries no official authority, and its contents should not be acted upon without professional advice. For more information about this topic, please contact our office.