Recently, with interest rates climbing, more people are starting to invest in bonds. It pays to know some of the different strategies you can use with bonds to bring in a steady stream of income while minimizing your risks. A question I often see on forums is:
“I have 10K that I want to invest, but I need the money in a year. Where do I invest it?”
Sometimes people have a hard time locking up the entire investment for a given period. For example, with I-bonds, you can’t pull them out for an entire year. Maybe you’re concerned you might need the money? Maybe it would put your mind at ease to have access to some of it. What else can you do besides buy a 1-yr Treasury note? 1 yr CD? Ibonds? This is where bond ladders come in handy.
One strategy is what’s called a bond ladder. A bond ladder sets it up to where pieces of your initial investment is returned to you over regular intervals. You’ll always have access to some portion of your initial investment. You can build a bond ladder in a number of ways:
Bond Ladder Example one:
You could purchase Treasuries at five different durations: $2000 each: 4 weeks, 8 weeks, 13 weeks, 26 weeks (6 months), and 1 year. You will always have $2000 plus your interest payments coming in each month. In some cases, when the 4 week and 8 week run concurrent, you’ll have $4000 coming in plus interest payments. This approach works well If your main concern is having access to the money. Over time, you essentially get more access to more of your cash.
The beauty of this approach is when the one month Treasury bill comes due, you take the amount and re-invest it into another one month Treasury (hopefully at a higher interest rate). You repeat this over and over until one year is up. At the same time, you do the same for the 8 week treasury bill as well after 8 weeks. The longest one, the one-year Treasury, is the only one that never comes due before the end of a year. At no point will you feel like all of your money is being tied up. At no point will you have one set in stone rate you are earning. If interest rates move higher after you buy your first bonds, you’ll have another opportunity to purchase bonds at a higher rate. This reduces your market risk.
Bond Ladder Example two:
You purchase an 8 week Treasury bill for $2000, then you put the next $2000 into a different 8 week Treasury (16 weeks after your initial investment), and so on. Here you are keeping the duration and amount the same, but are waiting every 8 weeks to start a new investment period. One issue with this approach is you will get your money invested slower as you’ll have to wait 8 weeks for the 2nd investment period, 16 weeks for the 3rd investment period and so forth. It will take a total of 40 weeks to get your entire $10K invested.
One main disadvantage to this is you aren’t taking advantage of various areas of the yield curve. You are always buying the same duration no matter what. In some cases, it may pay to buy the 1 year Treasury (or longer) at a higher rate.
Bond Ladder Example three:
You could come up with various hybrid approaches. For example, you could put in $2000 for short-term bills and only $1000 for the longer-term bills. This is type of the approach I’ve taken with some of my own bond ladders. I do this because I already have money locked into i-bonds for a year and I don’t want to commit larger sums of cash to longer bonds.
Decisions on how much to dedicate to what part of the yield curve will partly be driven by which direction you think interest rates are going. If you think interest rates are headed higher, you would lock up less money for longer-duration bonds. If you believe interest rates are going lower, then you purchase things at higher rates on the long end of the curve.
At the same time, I must warn you, it is almost impossible to predict where rates are going long-term.
Pros of a Bond Ladder
- In an environment where the interest rate is rising, your lower yielding bonds are replaced with higher yielding bonds at regular intervals.
- You never feel like all of you cash is tied up for an extended period of time.
- Cash flow is coming in at regular intervals.
- Reduces market risk.
Which this approach, if you buy a 1 month Treasury bill at a rate of 3.3% and then rates move up to 3.5%, you can quickly purchase a new bond at the new rate. Otherwise, without a ladder, you would only have a one-year Treasury that is locked at a given rate. That given rate could be lower than one later in the year.
The best thing about this approach is you are always getting income every single month. You don’t have to wait a year to see your first return (a psychological benefit).
Lastly, you always have pretty quick access to some portion of your capital if there is a crazy emergency in your life.
Hopefully you now have a good idea how to create a bond ladder. I think bond ladders are a great choice when you have money that you plan on using for a down payment, yet you are leery of locking it up for an extended period of time. It also works well during rising interest rates or in times of uncertainty.
Wishing you the best on your investment Journey