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How and why to build a bond ladder

A bond ladder can help to generate a stream of income and manage interest rate risk.

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History is littered with examples of prognosticators getting market calls wrong. Case in point: this year’s bond rally that few seemed to expect. What’s clear is that there is a lot of uncertainty surrounding the future of interest rates and the outlook for bonds. That’s one reason to consider a bond ladder.

“Laddering bonds may be appealing now because it may help you to manage interest rate risk, and to make ongoing reinvestment decisions over time, giving you the flexibility to invest in different credit and interest rate environments,” says Roger Young, senior vice president of fixed income at Fidelity Capital Markets.

Bond ladders are just one of many options for investors looking for steady income, from a simple CD to different flavors of annuities, individual bonds, or professionally managed funds. Like all these options, bond ladders have their advantages and disadvantages, but many investors decide to build a bond ladder because it can help manage the risks of changing interest rates and customize a stream of income, without ongoing management fees.

Managing reinvestment risk

Interest payments from the bonds in a ladder can provide scheduled cash flows. In addition, the ladder can help you manage reinvestment risk. Say you put all your fixed income investments in a single bond. That bond eventually would mature, the issuer would return your principal, and you’d have to purchase a new bond if you wanted to continue generating income or maintain your portfolio’s asset allocation mix. But if interest rates and bond yields had decreased in the meantime, you wouldn’t be able to generate as much income as before with the same amount invested—at least not without taking on additional investment risk. That’s a predicament some investors who rely on investment income won’t want to find themselves in.

Building a bond ladder that diversifies across a number of bonds that mature at different intervals has the potential to decrease this reinvestment risk. Imagine that yields fall as one rung in your ladder approaches maturity. If you choose to reinvest, you will only have to invest a fraction of your bond portfolio at the lower rate. Meanwhile, the other bonds in the portfolio will continue generating income at the relatively higher older rates. So the impact of falling rates may be smaller with a ladder than with a bullet strategy that targets a single maturity date or than with an investment in a small number of bonds.

What if yields and interest rates increase? A ladder may provide an advantage in this case as well. If you had invested all your money in a single bond, you’d miss out on the new, higher rates until it matured. By contrast, a bond ladder regularly frees up a slice of your portfolio, so you can take advantage of the new, higher rates.

“A bond ladder gives you a framework in which to balance the reinvestment opportunities of short-term bonds with the potentially higher yields that longer-term bonds typically offer,” says Richard Carter, Fidelity vice president of fixed income products and services.

Having a well-diversified bond ladder does not guarantee that you will avoid a loss, but it can help protect you the way that any diversified portfolio does, by helping to manage the risk of any single investment.

Bond ladder considerations

While building a bond ladder may help you to manage interest rate and reinvestment risk to some extent, there are six important guidelines to consider to make sure you are diversified and to attempt to protect yourself from undue credit risk.

1. Hold bonds until they reach maturity.

It’s important that you have enough money set aside to meet your short-term needs and deal with emergencies. You should also have a temperament that will allow you to ride out the ups and downs of the market. That’s because many of the benefits of bond ladders—such as an income plan and managing interest rate and credit risk—are based on the idea that you keep your bonds in your portfolio until they mature. If you sell early—either because you need cash or you change your investment plans—you will be exposed to additional risks including the risks of loss or decreased yield from your ladder. In fact, if you don’t hold bonds to maturity you may experience similar interest-rate risk as a comparable duration bond fund. So, if you don’t know how long you can hold the bonds you may want to consider a shorter ladder.

2. Start with at least $100,000.1

This isn’t a hard-and-fast rule, but because bonds generally must be purchased in minimum denominations (often $1,000), $100,000 or more is often required to achieve a degree of diversification across a broad range of different issuers in different sectors. In fact, you may need to start with a larger investment, depending on the types of bonds you wish to hold. The reason: The lower the credit rating of the bonds in a ladder, the greater the number of bonds that may be required to diversify against the risk of default. For example, with a ladder composed of corporate bonds, you may want to consider a minimum investment of at least $200,000. The table to the right shows the suggested number of issuers. If you can’t invest enough to diversify, you may want to look at other income options, like diversified bond mutual funds or annuities.

The table to the right offers some suggestions on how many different issuers may be required to help achieve diversification at different credit ratings.

3. Build your ladder with high-credit-quality bonds.

Because the purpose of a bond ladder is to provide consistent income over a long period of time, taking excessive amounts of risk probably doesn’t make sense. So you may want to consider only higher-quality bonds. You can use ratings as a starting point to find those bonds, for instance, select only bonds rated “A” or better. But even ratings have limits, they could change or be outdated, so you should also do additional research to ensure you are comfortable investing in a security that you are intending to hold for potentially many years.

How do bond ratings work?

Two of the major independent credit rating services are Moody's and Standard & Poor's. They research the financial health of each bond issuer (including issuers of municipal bonds) and assign ratings to the bonds being offered. A bond's rating helps you assess that bond's credit quality compared with other bonds.

bond_ladder_chart3_330

The bonds in a ladder are held until maturity, so price declines caused by rating downgrades generally won’t affect the income stream. But investors need to remember that bonds can go through more than one downgrade in rapid succession, heightening the market’s perception of default risk. Higher-quality bonds offer another advantage as well: These investments typically come with lower transaction costs, which can help manage the expenses associated with this strategy. Order size can also influence transaction costs—generally, a larger order will see lower transaction expenses per bond.

4. Avoid the highest-yielding bonds at any given credit rating.

You may feel tempted to choose the highest-yielding bonds for whatever credit rating you have chosen, figuring they represent a bargain—more yield for the same amount of risk.

Resist that temptation. You need to understand why a bond is offering a higher yield. An unusually high yield relative to other bonds with the same rating is often an indication that the market is anticipating a downgrade or perceives that bond to have more risk than the others and therefore has traded the bond’s price down (thereby increasing its yield). That can happen in advance of an official downgrade and may be too risky for your ladder. One potential exception is that in the municipal bond market, buyers often pay a premium for the most familiar issuers, meaning that higher yields may be available from smaller issuers.

5. Keep callable bonds out of your ladder.

Part of the beauty of a bond ladder is the scheduled cash flow; you know when the bonds will mature and you know how much you will need to reinvest. But when a bond is called prior to maturity, its interest payments cease and the principal is returned as of the call date—altering both your cash flow schedule and the schedule of principal coming due.

6. Think about time and frequency.

Another important feature of a bond ladder is the total length of time the ladder will cover and the number of “rungs,” or how often the bonds in the ladder are scheduled to mature, returning your principal. A ladder with more rungs will require a larger investment but will provide a greater range of maturities, and if you choose to reinvest, this means you will have more opportunities to gain exposure to future interest rate environments.

A case study: building a bond ladder

To see how you can build a ladder using Fidelity’s Bond Ladder Tool, let’s take a hypothetical case in which Matt wants to invest $100,000 to produce a stream of income until he reaches retirement, in about 10 years. Matt decided to start with his investment amount—though the tool would have let him target a level of income as well. He set his timeline and asked for a ladder with five “rungs” of about $20,000 each. Then he chose bond types. In order to be broadly diversified, the rungs each contained a range of bonds and FDIC-insured CDs at different credit rating levels, but all of them were at least investment grade.

Matt elected the option to have the tool suggest bonds for each rung. So on the next screen, the tool suggested a bond for each rung of the ladder and showed a summary of the ladder, including the expected yield and annual interest payments.

Another view lets Matt review the schedule of when to expect interest payments and the return of principal—providing a predictable view into the cash flow he could expect if he chooses to purchase the suggested bond ladder.

Matt’s expected cash flows appears to decrease over time, but he may be able to extend that income by reinvesting the returned principal each time one of the bonds matures.

Learn more

If you’re ready to build a bond ladder, consider using the online Fidelity Bond Ladder Tool. It walks you step by step through the process and helps you to gauge your time horizon, comfort level with risk, and income needs—and identifies choices that fit your criteria from a typical inventory of more than 40,000 bonds and CDs.

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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. Lower-quality fixed income securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Foreign investments involve greater risks than U.S. investments, and can decline significantly in response to adverse issuer, political, regulatory, market, and economic risks. Any fixed-income security sold or redeemed prior to maturity may be subject to 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. In addition, you may 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 official statement for the relevant offering for additional tax and other considerations.
The municipal market can be adversely affected by tax, legislative, or political changes and 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 adviser regarding your specific situation.
1. For investments of less than $100,000 ($200,000 when using corporate bond ladders), you may want to consider purchasing bond funds for purposes of diversification.
Fidelity Capital Markets is a division of National Financial Services LLC. National Financial Services LLC is a Delaware limited liability company and registered broker-dealer, and a Fidelity Investments company. Dependable income is subject to the credit risk of the issuer of the bond. If an issuer defaults no future income payments will be made.
A bond ladder, depending on the types and amount of securities within the ladder, may not ensure adequate diversification of your investment portfolio. This potential lack of diversification may result in heightened volatility of the value of your portfolio. You must perform your own evaluation of whether a bond ladder and the securities held within it are consistent with your investment objective, risk tolerance and financial circumstances. To learn more about diversification and its effects on your portfolio, contact a Representative: 1-800-544-6666.
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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