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How to earn steady income with bonds

Key takeaways

  • Interest rates have risen high enough that bonds can deliver reliable income with less risk than stocks.
  • Owning bonds with a variety of maturities can help provide you with a source of predictable income even if rates move lower in the future.
  • Ladders should be built with high-quality, noncallable bonds.
  • Fidelity's bond experts can help you build a ladder that reflects your need for income, tolerance for risk, and time horizon.
  • Fidelity's bond ladder tools can help self-directed investors who want to ladder bonds.

People who are retired or are nearing retirement likely want reliable income to meet their needs. While some people may have pensions to supplement Social Security payments, most must rely on investments to deliver additional income to cover expenses.

For many years following the 2008 global financial crisis, interest rates on bonds, certificates of deposit (CDs), and cash were very low and many investors turned away from them in favor of stocks. After almost 2 years of rising interest rates, though, people who want alternatives to potentially volatile stocks may find that high-quality bonds and CDs can deliver attractive returns with far more predictability and less risk than stocks can offer.

If you want to generate income after you have retired or while you are transitioning away from full-time work, building a ladder of individual bonds could offer reliable income, preserve the value of your portfolio, and give you peace of mind well into the future.

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What's a bond ladder?

A popular way to hold individual bonds is by building a portfolio of bonds with various maturities: This is called a bond ladder. Ladders can help create predictable streams of income, reduce exposure to volatile stocks, and manage some potential risks from changing interest rates.

The Federal Reserve is expected to keep interest rates relatively high until it decides inflation has been brought under control but could lower rates if the economy weakens. If and when rates begin to fall, a bond ladder structure will help ensure that at least part of your bond portfolio is maintained at the (higher) yields that prevailed when you had originally invested in the ladder. Similarly, a ladder may be useful when yields and interest rates rise because it regularly frees up part of your portfolio so you can take advantage of new, higher rates in the future. If all your money is invested in bonds that mature on the same date, they might mature before rates rise or after they have begun to fall, limiting your options.

By contrast, bonds in a ladder mature at various times in the future, which enables you to reinvest money at various times and in various ways, depending on where opportunities may exist. Ladders can also offer some protection from the possibility that rising rates might cause bond prices to fall, since bond holders are paid the full principal value of the bond when it matures (assuming the issuer stays in business and can make good on its borrowing as they come due).

"Laddering bonds may be appealing because it may help you to manage interest-rate risk, and to make ongoing reinvestment decisions over time, giving you the flexibility in how you invest in different credit and interest rate environments," says Richard Carter, Fidelity vice president of fixed income products and services. (Note that the chart that follows is for illustrative purposes only and that yield rates are subject to changing market conditions.)

How ladders may help when rates are falling

Interest payments from bonds can provide you with income until they mature or are called by the issuer. When that time comes, there’s no guarantee you’ll find new bonds paying similar interest because rates and yields change frequently.

Laddering bonds that mature at different times lets you potentially diversify this risk across a number of bonds. Though a bond in your ladder might mature while yields were falling, your other, longer-dated bonds would continue generating income at the higher older rates.

Things to know before building a bond ladder

Before building a bond ladder, consider these 6 guidelines.

1. Know your limitations

Ask yourself—or your advisor—whether you have enough assets to spread across a range of bonds while also maintaining adequate diversification within your portfolio. You don't want all of your money in any one type of investment and even bond enthusiasts recommend leaving at least 40% of your portfolio in stocks. Bonds are often sold in minimum amounts of $1,000 or $5,000, so you may need a substantial investment to achieve diversification. It may make sense to have at least $350,000 toward the bond portion of your investment mix if you're going to invest in individual bonds containing credit risk such as corporate or municipal bonds.1 For smaller amounts, consider a Treasury or CD Ladder, where credit risk is considerably reduced.

Make sure that you also have enough money to pay for your needs and for emergencies. Also consider whether you have the time, willingness, and investment acumen to research and manage a ladder yourself or if you would be better off getting help with your ladder or opting instead for a bond mutual fund or separately managed account.

2. Hold bonds until they reach maturity

You should have a temperament that will allow you to ride out the market’s ups and downs. That’s because you need to hold the bonds in your ladder until they mature to maximize the benefits of regular income and risk management. If you sell early, you will risk losing income and may also incur transaction fees. If you can't hold bonds to maturity, you may experience interest-rate risk similar to a comparable-duration bond fund, which you may want to consider instead.

How many issuers might you need to manage the risk of default?

Credit rating # of different issuers
AAA US Treasury 1
AAA-AA municipals 5 to 7
AAA-AA corporate 15 to 20
A corporate 30 to 40
BAA-BBB 60+
For illustration only. Please note: More or fewer issuers may be required to achieve diversification. Investors may want to consider other diversification factors, including industry and geography.

3. Use high-quality bonds

Ladders are intended to provide predictable income over time, so using riskier lower-quality bonds makes little sense. To find higher-quality bonds, you can use ratings as a starting point. For instance, select only bonds rated "A" or better. But ratings can change, so you should do additional research to ensure you are comfortable investing in a bond you may potentially hold for years. If you are investing in corporate bonds, particularly lower-quality ones, you need more issuers to diversify your ladder. The prior table suggests how many issuers you may need.

How do bond ratings work?

Moody's and Standard & Poor's are independent credit rating services that analyze the financial health of bond issuers. The ratings they assign help investors assess how likely an issuer is to be able to make principal and interest payments to bondholders.

4. Avoid the highest-yielding bonds

An unusually high yield relative to similar bonds often indicates the market is anticipating a downgrade or perceives that bond to have more risk than others and has traded its price down and increased its yield. One potential exception is municipal bonds, where buyers often pay a premium for familiar bonds that may have higher yields from smaller—but still creditworthy—issuers.

5. Keep callable bonds out of your ladder

Part of the appeal of a ladder is knowing when you get paid interest, when your bonds mature, and how much you need to reinvest. But when a bond is called prior to maturity, its interest payments cease and the principal is returned to you, possibly before you want that to happen.

6. Think about time and frequency

Another feature of a ladder is the length of time it covers and how often the bonds mature and return principal. A ladder with more bonds will require a larger investment but will provide a greater range of maturities. If you choose to reinvest, you will have more opportunities to gain exposure to future interest-rate environments.

How to build a bond ladder

Here’s an example of how you can build a ladder using Fidelity's Bond Ladder tool. Mike wants to invest $400,000 to produce income for about 10 years. He starts with his investment amount—though he could also have chosen a level of income. He sets his timeline and asks for a ladder with 21 rungs (that is, 21 different bonds with different maturities) with approximately $20,000 in each rung. Then he chooses bond types. In order to be broadly diversified, each rung contains a range of bonds and FDIC-insured CDs with various investment grade credit ratings.

Mike lets the tool suggest bonds for each rung. The tool suggests bonds and shows a summary of the ladder, including the expected yield and annual interest payments.

Displayed rates of return, including annual percentage yield (APY), represent stated APY for either individual certificates of deposit (CDs) or multiple CDs within model CD ladders, and were identified from Fidelity inventory as of the time stated. For current inventory, including available CDs, please view the CDs & Ladders tab.

While a well-diversified bond ladder does not guarantee that you will avoid a loss, it can help protect you the way that any diversified portfolio does, by helping to limit the amount invested in any single investment. Also, a bond ladder leverages the cash flow features of bonds in terms of their coupons and principal repayments: This gives it the potential to be an efficient and flexible vehicle with which to create an income stream tailored to the time period, with a payment frequency to meet your needs.

Need help building a bond ladder? On Fidelity.com, you can research fixed income solutions or fixed income tools and services. Prefer to talk to an expert? Call our specialists in fixed income at 800-544-5372.

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More to explore

1. If the fixed income portion of your strategic asset allocation is less than $350,000, you may want to consider purchasing bond funds for purposes of diversification. The Bond Ladder Tool is an educational tool and is not intended to serve as the primary basis for your investment, financial or tax planning decisions. The results of the tool are based on your inputs and criteria and the tool's stated methodology.

This information is intended to be educational and is not tailored to the investment needs of any specific investor.

Views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

Interest income earned from tax-exempt municipal securities generally is exempt from federal income tax and may also be exempt from state and local income taxes if you are a resident in the state of issuance. A portion of the income you receive may be subject to federal and state income taxes, including the federal alternative minimum tax. You may also be subject to tax on amounts recognized in connection with the sale of municipal bonds, including capital gains and “market discount” taxed at ordinary income rates. Market discount arises when a bond is purchased on the secondary market for a price that is less than its stated redemption price by more than a statutory amount. Before making any investment, you should review the relevant offering's official statement for additional tax and other considerations.

The municipal market can be adversely affected by tax, legislative, or political changes, and by the financial condition of the issuers of municipal securities. Investing in municipal bonds for the purpose of generating tax-exempt income may not be appropriate for investors in all tax brackets or for all account types. Tax laws are subject to change, and the preferential tax treatment of municipal bond interest income may be revoked or phased out for investors at certain income levels. You should consult your tax advisor regarding your specific situation.

Predictable income is subject to the credit risk of the issuer of the bond. If an issuer defaults, no future income payments will be made. Rating agencies grade bonds on a letter scale that indicates credit worthiness and risk. In simplest terms, the lower the letter scale, the lower the quality and the higher risk potential: AAA or triple A rating—indicates the highest-quality bonds that offer the highest protection for principal and interest payments; A or single A rating—indicates good to medium-grade bonds; BBB or triple B rating—indicates medium-grade quality bonds, with adequate protection; Below triple B is considered speculative, high-risk securities and the category is referred to as junk bonds. Learn more A bond ladder, depending on the types and amount of securities within it, may not ensure adequate diversification of your investment portfolio. While diversification does not ensure a profit or guarantee against loss, a lack of diversification may result in heightened volatility of your portfolio value. You must perform your own evaluation as to whether a bond ladder and the securities held within it are consistent with your investment objectives, risk tolerance, and financial circumstances. To learn more about diversification and its effects on your portfolio, contact a representative: 1-800-544-6666. For the purposes of FDIC insurance coverage limits, all depository assets of the account holder at the institution issuing the CD will generally be counted toward the aggregate limit (usually $250,000) for each applicable category of account. FDIC insurance does not cover market losses. All the new-issue brokered CDs Fidelity offers are FDIC insured. In some cases, CDs may be purchased on the secondary market at a price that reflects a premium to their principal value. This premium is ineligible for FDIC insurance. For details on FDIC insurance limits, visit FDIC.gov. Fidelity Investments does not provide tax or legal advice so you may want to consult an attorney or tax adviser regarding the portfolio bonds you have identified before purchasing your ladder.

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