When someone says they are going to build a bond ladder, it means bonds are purchased in their account so that the maturity dates of the bonds are staggered, or laddered, across a specified period of time.
Bond Ladder to Meet Cash Flow Needs
For example, if you are an extremely conservative, or risk adverse investor, you might take your entire portfolio and buy bonds so that one bond matures each year for the next thirty years, to meet cash flow needs. This would be a thirty year bond ladder.
Bond Ladder As Part of A Balanced Portfolio
If you are investor with a moderate risk tolerance, retiring with $1 million, you might take $400,000, or 40% of your portfolio, and buy eight bonds with a face value of $50,000 each. The first bond would mature in one year, the next would mature in two years, the next in three years, and so forth, thus laddering the bond portfolio over an eight year period.
The remaining $600,000 would be invested in stocks(equities preferably in the form of index funds) to grow. Eight years later, at an 8% rate of return, the $600,000 would grow to $1.1 million, allowing you to sell $500,000 of stocks to create another bond ladder.
The Practical Application of A Bond Ladder
Practically speaking, you would not actually wait eight years before selling off stocks to ladder out more bonds. Instead, in years with strong stock market returns, you would sell equities, and add bonds to the end of your bond ladder.
In years with poor stock market returns, you would not sell equities. If you had several years of poor stock market returns, you may get down to a point of having only two to three years of laddered bonds left. That’s ok, as the whole point of creating the bond ladder is to give equities the time they need to earn decent returns.
Alternatives to A Bond Ladder
In lieu of a bond ladder, you could create a CD ladder, with certificates of deposit maturing each year to meet cash flow needs. It may be beneficial to price both CD’s and bonds, for any given time frame, to determine which would give you the highest yield.
You could also use a fixed annuity, instead of a bond or CD, as part of your ladder. Again, you would want to determine which investment, or combination of investments, would provide you with highest yield for any given maturity date.
Learn more: How Do You Determine How Much Money I Can Safely Withdraw Each Year Without Running Out?
How Much of My Money Should Be in Stocks vs. Bonds?
