Learn how you can utilize bond and CD laddering to reach your future goals
Bond & CD Laddering Basics:
Laddering is a process by which you have a portfolio of fixed-income securities (usually Bonds or CD’s) in which each security has a significantly different maturity date.
By using the laddering process you can purchase several smaller bonds or CD’s with different maturity dates rather than one large bond or CD with a single maturity date, thereby minimizing interest-rate risk and increasing your liquidity (ability to get your cash in a more timely manner) at the same time.
In a Bond or CD ladder, the bonds’ maturity dates or the CD’s maturity dates are evenly spaced across several months or several years so that the bonds or CD’s are maturing and the proceeds are being reinvested at regular intervals.
If you wanted more liquidity you would select maturing dates that are closer together.
Laddering strategies can be utilized inside or outside of your retirement accounts and are particularly effective when you select the bond or CD to mature outside of your retirement account in consecutive years—thereby reducing your taxes.
The purpose of laddering is to lock in predictable income by dividing your money among bonds or CD’s maturing at regular intervals—say one to five years. When each bond or CD comes due you could reinvest for another interval or pull the money out.
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ETF’s & Laddering:
You can also use ETF’s to build a bond ladder but the income (interest payment and final distribution) would not be as predictable because at maturity they distribute assets back to shareholders.
On the plus side bond laddering using ETF’s are less costly than laddering with individual bonds ($10,000 or more is normally needed with individual bonds) and they are a growing segment with a number of companies now offerring ETF bond ladders.
Bond Laddering Example:
If you had one $50,000 bond that matured in five years and earned 4.5% interest per year, you would not have access to that full $50,000 for five years. Also, if interest rates increased to 5.5%, you would be stuck earning the lower, 4.5% rate until the bond matured.
On the other hand, if you had five bonds worth $10,000 each that were laddered so that one bond matured each year, you would only have to wait months to start earning a higher interest rate on a portion of your investment if interest rates increased.
At the same time, if interest rates fell from 4.5% to 3.5%, you would not be faced with putting $50,000 into a lower-earning investment all at once. Interest rates might go back up by the time the other bonds reached their maturity dates and that is a key component of the laddering strategy.
CD (Certificate of Deposit) Laddering Example:
Likewise if you laddered your CD’s with a $50,000 CD that matured in five years and earned 4.5% interest per year, you would not have access to that full $50,000 for five years (without incurring a penalty). Also, if interest rates increased to 5.5%, you would be stuck earning the lower, 4.5% rate until the CD matured.
On the other hand, if you had five CD’s worth $10,000 each that were laddered so that one CD matured each year, you would only have to wait months to start earning a higher interest rate on a portion of your investment if interest rates were to increase.
At the same time, if interest rates fell from 4.5% to 3.5%, you would not be faced with putting $50,000 into a lower-earning CD all at once. Interest rates might go back up by the time the other CD’s reached their maturity dates and that is a key component of the laddering strategy.
Final Thoughts on Bond & CD Laddering
Bond price movement and yield can often be difficult to predict as 2014 defied many of the experts and bond holders and other income investors did pretty well. The yield on the benchmark 10 Year Treasury dropped from 2.6% to 2.3% and long-term government debt returned 13.1% over the past year as of October 31st, 2014.
Municipal Bonds also had an excellent year as they returned 12.6% on average while REIT’s (Real Estate Investment Trusts) and Utilities also did quite well. Energy bonds and Junk bonds were down some in 2014. Even though the FED’s have voted to end their massive bond-buying program—bonds and bond funds can be an important part of your portfolio if you are properly positioned to invest at this time.
Even if the FED was to start hiking rates in 2015, inflation concerns would be reduced and the likelihood of long-term bond rates rising significantly would be reduced.
However, CD’s and other fixed rate instruments could finally see positive upward movement if the FED was to start hiking interest rates.
In 2015 many are forecasting long-term rates to climb by about half a percentage point. The ten year Treasury is expected to end near 3.3%. As far as home mortgage rates—forecasters predict the rate will end the year of 2014 at 4.4% and end the year of 2015 at 5.1% which is not bad considering the job market and home inventory levels.
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About This Article:
The above article was written by Thomas (TJ) Underwood on December 14, 2014. Thomas (TJ) Underwood is a licensed real estate broker in the state of Georgia and is the writer behind The Wealth Increaser, Home Buyer 411, Home Seller 411, The 3 Step Structured Approach to Managing Your Finances, Managing & Improving Your Credit & Finances for this MILLENNIUM and CREDIT & FINANCE IMPROVEMENT MADE EASY—FREE GUIDE.
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