To a lot of people, bond ladders sound like another one of those complicated finance concepts only investing geeks understand, but they’re actually pretty simple. I think the easiest way to view them is as though you’re setting up your own annuity by prepaying for at least some of your income in retirement.
Basically, a bond ladder is a series of bonds designed to act as a source of income through payouts spaced out over the course of a predetermined length of time. Generally, you buy bonds that mature every year and provide a portion (or potentially all) of your income for the year.
If I wanted to set up a bond ladder that paid out for ten years starting in 2020, I could buy bonds that will mature in 2020, 2021, 2022, etc., until the end of the ladder in 2029.
The key here is that you hold the bonds to their scheduled maturity date, so you don’t need to worry about what the market’s doing, as long as the bonds you own don’t default. The bond issuers have a contractual obligation to pay you what they promised. You will get the coupon and principal payments specified in the bond, so you can trust that you will get the income you expect.
Bond ladders allow you to offload a lot of the risk inherent in the financial markets – but not all of it. You don’t need to worry about the general noise of the stock (or even bond) markets, and the variability that can mean for your retirement income.
However, bond ladders still have risks:
Because you are buying individual bonds, you need to be careful about default risk. Whenever you buy a bond, there is always the risk that the issuer will not be able to make the scheduled payments. If one of the bonds in your ladder defaults, then you have a big problem. When a bond that you own defaults you don’t necessarily lose everything, but the process becomes a lot more complicated, and you probably won’t be getting that payment when you need it. If that bond was scheduled to mature in 2021, then a large part of your income for 2021 just disappeared.
Stick with safe and conservative issuers whenever possible. You don’t have to go exclusively with government bonds, but you be cautious when venturing into corporates.
Reinvestment risk is just a fancy way of saying that no one knows what the future will look like. Interest rates could go up, making bonds cheaper, or they could drop, making bond prices rise.
This may seem a little more abstract than default risk (it’s a little easier to understand why a default is bad), but its significance depends on your future plans.
If you are going to alter the ladder in any way after you first set it up – extend it past your initial purchases, add to it over time, or reinvest cash paid out from the bonds before you want to start using those payments for income – then reinvestment risk should be on your radar. The more you can lock down when you set up the bond ladder, the less uncertainty you will deal with in the future.
One More Thing
Bond ladders are also a backstop for catastrophic risks. If something serious happens to you, you can always take an advance on your future income by selling some of the bonds in your ladder. Generally, this should only be used as a last resort, but it’s nice to know the option is available.
Bond ladders aren’t for everyone. Just like a traditional income annuity, you are essentially paying to be certain of your retirement income. And unfortunately, that certainty doesn’t usually come cheap. Depending on how much income you want to generate, you may need to allocate a large portion of your investment portfolio to the bond ladder, but they can be great tools to generate reliable income in retirement, while also giving you a little bit more flexibility than a traditional income annuity.
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