Monday, 26 October 2015

Using Bond Ladders for Income

Using Bond Ladders for Income

Bond ladders are just one of many options for investors looking for predictable income. 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 customise a stream of income, without ongoing management fees.

Building a bond ladder that diversifies across a number of bonds that mature at different intervals has the potential to decrease reinvestment risk. As yields and interest rates increase and decrease, a ladder may provide an advantage allowing you to adapt to changes with small parts of your portfolio instead of having to commit all of it at a single time.

Bond ladder considerations
While 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, to protect yourself from undue credit risk or both.

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. 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.

2. How many issuers might you need to manage the risk of default?
This isn’t a hard-and-fast rule, but because bonds generally must be purchased in minimum denominations (often €1,000). €20,000 or more is often required to achieve a degree of diversification across a broad range of different issuers in different sectors.

3. Build your ladder with high-credit-quality bonds.
Because the purpose of a bond ladder is to provide predictable 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.

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).

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, when the interest will be paid 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.

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