A bond ladder is a strategy of buying a set of bonds that mature at regular periods. For example, a simple bond ladder with five rungs to the ladder can be created by first dividing up a block of cash into five equal cash amounts. To get a steady stream of income with the five bond purchases, the bonds need to mature at equal intervals of time.
For example, a bond ladder that spans 10 years can be created by following these simple steps:
1. Use the first block of cash to purchase a 2-year bond. This creates the first rung of the bond ladder.
2. The next rung of the bond ladder would be created by purchasing a bond that matures in 4 years.
3. Following the pattern set in the steps 1 and 2, the next three bond purchases would be a 6-year, 8-year and 10-year bond, respectively.
Now, a bond will mature every two years after the initial purchase. At maturity, the bond value and interest will be returned. At this point, the principal, the original money used to buy the bond, will be reinvested in a 10-year bond in order to continue having a bond mature every two years. And the interest returned with the bond principal can be used in a different investment or spent. To grow wealth, it’s better to put the interest paid in a holding account, such as a savings account, that allows for flexibility to use the money when a good investment opportunity comes along. In this way, the ladder will continue to create interest income every two years while preserving the original cash to buy new bonds. The bond ladder will work with any type of bond that is sold on the market.
How much do you need to make a bond ladder work? Most examples show how to create a bond ladder with $10,000. This leads readers to the erroneous conclusion that a large amount of money is needed to create a bond ladder. But a bond ladder can be created with a much smaller amount. Even buying a set of treasury bonds, what most people think of as United States savings bonds starting at denominations of $25, with different maturity dates can create a bond ladder.
Or if investment principal is at least $500, so that it can be divided equally into five purchases of $100 each, a bond ladder can be built out of Treasury Inflation-Protected Securities (TIPS). The advantage of using TIPS for a low-cost bond ladder is that the principal used to purchase each bond is automatically adjusted for inflation. This is a built-in feature of Treasury Inflation-Protected Securities.
As with all investments, there is a degree of risk. The assumption behind creating a bond ladder is that the agency or company selling the bond doesn’t default or go out of business. Researching the bond market to look for safer bonds that may pay smaller amounts of interest payments, but are less likely to default is key to creating a successful investment experience.